In this article we will discuss about:- 1. Conversion of a Foreign Branch to a Foreign Subsidiary 2. Repatriation of Profits 3. Liquidation of Companies 4. Cross-border Leasing 5. Foreign Direct Investment.
- Conversion of a Foreign Branch to a Foreign Subsidiary
- Repatriation of Profits
- Liquidation of Companies
- Cross-border Leasing
- Foreign Direct Investment
1. Conversion of a Foreign Branch to a Foreign Subsidiary:
In a new foreign undertaking, there are likely to be start-up losses. During this period, the tax planner will be interested in the rules regarding tax incentives and the carry-forward of operating losses and depreciation allowances.
In a corporate structure, his objective is to ensure that these tax benefits are not wasted due to time limits. If tax holidays are given, it should be possible to use the tax incentives and allowances even after the holiday period, preferably in full.
Alternatively, a branch structure may be used during the initial period of losses. Unlike a company, a branch allows the start-up losses to be offset against the profits of the parent enterprise.
These initial losses may also be carried forward within a newly incorporated company for offset a second time against its future profits. Therefore, it is common tax planning to operate initially as a branch and to convert it into a subsidiary once the operation becomes profitable.
Essentially, the conversion from a branch to a subsidiary involves a disposal of the foreign branch and the acquisition of its business and net assets by a new foreign subsidiary. The realization of the assets and the hidden reserves of the branch at the market value could result in a tax liability due to the recapture of past depreciation and other allowances.
There may also be a capital gains tax to pay on the market value of the assets and goodwill in both the home and the host country. The carry-over of tax losses and other tax attributes may be lost. The transaction may also involve capital taxes and stamp duties.
Thus, the transfer of branch assets to a subsidiary has tax consequences in both the host and home jurisdictions. The home state may or may not defer or roll over the capital gains on the transfer of the assets.
The tax benefits of past branch losses set-off against the company’s taxable profits may be recaptured. Similarly, the host country may or may not tax the capital gains and disallow the carry-forward of branch losses.
In some cases, it may be possible to minimize these taxes through appropriate tax planning. The foreign taxes paid on the sale of the assets in the host country should be creditable against the tax liability on the same sale at home.
In certain situations, the branch could avoid or defer the tax liabilities through the lease of the fixed assets, and the sale of inventory on a consignment basis, to the subsidiary. The payment for goodwill by the subsidiary may be characterized as a tax-free royalty payment to the parent company under a tax treaty.
Many countries allow the capital gains to be rolled over. For example, several home countries defer the capital gains except in cases of tax abuse. Similarly, several host jurisdictions allow the transfer of assets and business to be made tax-free to a resident subsidiary, and even permit the carry-over of unused tax losses of the branch.
However, there are some countries that disallow the future use of branch losses. In the latter situation, the subsidiary should not take over the branch until the branch has earned sufficient profits to absorb all its past tax losses.
The domestic tax rules on branch conversion vary widely. For example:
Canada allows a roll-over or non-recognition of any capital gains on the transfer of branch assets to a qualified related Canadian corporation, provided the consideration for the transfer includes shares of the corporation. The conversion may, however, lead to the recapture of any investment allowance claimed by the branch.
France taxes the unrealized gains and goodwill on the conversion, except under the EC Merger Directive. A tax-free conversion is possible, with prior approval, if France retains the right to tax any gains on the future sale of the shares of the new subsidiary. Normally, the foreign shareholder must agree to hold the shares through a French subsidiary for five years.
The Netherlands permits tax-free asset transfer and carry-over of branch losses to the new subsidiary, provided the entire business is transferred in exchange for shares and the parent company retains the shares for at least three years.
The assets and liabilities are transferred at the base cost to the branch. A foreign branch of a Dutch company may also be converted tax-free into a subsidiary. However, the parent company will not qualify for participation exemption for an amount equal to the branch losses incurred in the previous eight years.
Switzerland allows the carry-over of losses and the deferral of capital gains on the incorporation of a branch into a Swiss resident (non-holding) company, provided the entire business and ownership remain the same. The assets of the branch are transferred at the same base value as their original cost.
(v) United Kingdom:
The transfer of assets and trade of a UK branch to a company does not lead to capital gains tax, provided the foreign company continues to own more than 75% of the new subsidiary. Moreover, the branch losses may be carried forward in the subsidiary.
A UK company converting a foreign branch into a company will be liable to pay capital gains unless the consideration consists entirely of shares and loan stock. The deferred gain is taxable if the transferred assets are sold or retired within six years.
(vi) United States:
The United States allows a tax-free conversion of a US branch to a corporation, provided at least 80% ownership (direct and indirect) remains unchanged, but the branch losses cannot be carried over.
A foreign branch of a US corporation may be converted with prior approval without a capital gains liability, if the transfer is not for tax avoidance purposes. However, previously deducted branch losses may be recaptured to the extent of the deemed capital gains on the transfer, if the assets were sold to a third party.
Mergers and Acquisitions:
According to an UNCTAD World Investment Report issued in 1997, mergers and acquisitions account for 20% of all foreign direct investment in developed countries and 10% in developing countries. Roughly two-thirds of the cross-border acquisitions involve a controlling interest.
An acquisition involves either the purchase of assets or the purchase of shares of a company. These shares may be existing or new shares, and may involve complete ownership or merely the shares that give the investor a controlling interest.
Mergers differ from acquisitions. A merger is based on the absorption of an existing company through an amalgamation. A merger through share-for-share exchange can never lead to complete ownership, but it is still possible for the acquiring company to own more than 50% equity or voting rights.
A cross-border transaction involves a merger with a locally owned subsidiary of the foreign company, i.e. a domestic merger. True mergers between a foreign and domestic company are not common.
An acquisition or merger leads to several tax considerations. There may be capital duty on the issue of new shares, stamp duties on the transfer of shares or assets, and capital gains tax on the sale of shares or assets. There may be a loss of tax attributes. The foreign investor is also concerned with the withholding tax on future dividends and the treaty provisions that reduce this rate.
If the foreign purchaser acquires a controlling interest, he may be liable to pay tax on the undistributed income of the subsidiary at home under the controlled foreign corporation rules. Non-tax considerations include exchange controls and other local regulations over foreign investors.
As mentioned, an acquisition involves either the purchase of assets or the purchase of shares of a company. The choice between the purchase of assets of the company or its shares affects the buyer and seller differently.
(a) Asset Purchase:
A purchaser normally prefers an asset acquisition due to his concern over the liabilities (particularly contingent liabilities) of the acquired company in a share purchase. An asset purchase may be unavoidable if he intends to purchase only some of its assets or to acquire a non-corporate entity.
In an asset purchase, a local subsidiary or branch normally makes the acquisition, and the interest on the funds borrowed for the acquisition is deductible from the related future income flows. As the purchaser acquires the assets at their fair market value, they are fully depreciable for tax purposes in the future.
Many countries also allow the tax amortisation of the payments for intangibles, such as goodwill and the non-complete covenant. However, the buyer does not get the tax attributes of the acquired company (e.g. unused tax loss carry-forwards, foreign tax credits, capital losses, etc.). There is also the cost of the setup of a new subsidiary or branch in the host country to acquire the assets.
The purchase of assets is not normally tax beneficial for the seller. The transfer of inventory at the market price leads to a taxable profit, while the past depreciation allowances are recaptured if the sale price exceeds the written-down value of the assets. There may also be capital gains to pay if the assets have gone up in value.
The transaction may involve high transfer taxes (e.g. stamp duties), particularly on immovable property. Finally, the sale of assets, followed by the subsequent distribution of the proceeds to the shareholders, may lead to double tax payment on the same capital gains. The tax is first payable by the company when it sells the assets, and again by the shareholders when the liquidation surpluses are distributed to them.
(b) Share Purchase:
The seller prefers the transfer of shares. It involves a single capital gains tax on the selling shareholders. Moreover, the transfer of shares is usually easier and less expensive than the purchase of assets. In the purchase of shares, the corporate entity and its tax attributes are normally retained.
However, many countries limit the loss carry-forwards when there is a change in ownership, or a change in the nature of the business. A share acquisition could, therefore, involve a loss of tax attributes such as past operating losses and other unused tax benefits.
The purchase price of the shares must be adjusted for any latent or contingent liabilities (e.g., future pension costs) and asset values. As the assets are acquired at the depreciated tax value, the price consideration has to be adjusted for the lower tax basis (i.e. written- down value) of the acquired assets.
In some countries the tax basis of the assets may be “stepped up” to the purchase price less liabilities in a share transfer. The acquired corporation is then liable to tax on the recapture of the past tax benefits, and it loses the carry-over of the tax attributes. Although the “stepped up” basis is possible in certain circumstances, generally any advantage to the buyer is outweighed by the additional tax cost to the seller.
Most international acquisitions involve the purchase for cash and not a share-for- share exchange with foreign shareholders. Although an exchange is attractive from a commercial viewpoint, such an exchange would require the foreign shares to be readily marketable in the host country.
It would also create tax issues for the new foreign shareholders in the acquired company. For example, they would be subject to the withholding taxes on the dividends that they receive from the parent company, with the possible problems of excess foreign tax credits or the loss of imputation credits.
The attempts by foreign parent companies to pay the dividends directly to the shareholders in the country in which the income is earned have led to structures such as the “stapled share” arrangements. The dividends are paid on these stapled shares directly to the shareholders in the country from the profits of the subsidiary.
2. Repatriation of Profits:
Multinational entities prefer to retain their foreign profits for reinvestment or expansion abroad. In certain countries they are taxable currently at home under the controlled foreign corporation rules.
In other cases, they are taxed only on distribution, unless they are tax-exempt (e.g. participation exemption). Some of these funds may be required to pay dividends to the shareholders at home, or for compliance with domestic regulations e.g. exchange controls.
The tax-planning objective on such profit repatriation is generally to extract the funds from the host country at a lower tax cost than the rate applicable on the remittances of post-tax profits to the home country.
The post-tax profits are usually distributed by the foreign subsidiaries as dividends, subject to withholding tax. The use of an intermediary holding company may help to reduce the withholding tax under a treaty with the host country and to shelter the inbound income (“primary sheltering”).
It may also avoid or reduce the tax liability on outbound payment through tax planning (“secondary sheltering”). For example, the inbound dividend income received from the underlying subsidiaries may be re-characterized as a tax-exempt payment (e.g. capital gains) when paid out to the parent company. The subsidiary or intermediary company may also make an upstream loan to the parent company.
The pre-tax earnings of an overseas subsidiary may be transferred to either the home or intermediary jurisdiction through extraction techniques, such as the payment of interest, royalties, management or service fees, or by the allocation of other centralized costs under the arm’s-length principle.
If the subsidiary is financed with debt, the retained profits may also be repatriated as interest and loan repayment. Therefore, tax planning should normally provide for the use of the maximum amount of permitted debt financing.
Other tax-free repatriation methods include redeemable preference shares, a reduction in the share capital or share buy-back, or the sale or liquidation of the subsidiary itself.
The parent company could also create a receivable through the sale of its assets to the subsidiary, or arrange for it to buy the shares of another subsidiary. The subsidiary may also be used by the parent company to finance the acquisition of assets or shares in other companies.
3. Liquidation of Companies:
The liquidation of a company’s activities results in two types of profit:
(i) The income from the operations during the liquidation period; and
(ii) The capital gains on the realization of the market value of the business assets. Most countries tax these profits of the company during the normal liquidation process, either annually or when the liquidation is completed.
The shareholder receives the liquidation proceeds as a repayment of capital and a final dividend or capital gains (or loss). The return of capital to the shareholder should normally be tax-free. This amount may or may not be adjusted for inflation and the repayment, therefore, may not reflect its current value. Certain countries provide for a lower tax rate on a revalued capital base.
The taxation of liquidation surpluses paid to shareholders varies widely. Some countries treat the payment of liquidation surplus as a dividend, while others treat them as capital gains. Some countries apply a mixed system and tax it partly as a dividend and the balance as capital gain. Certain countries tax-exempt these liquidation surpluses when paid to nonresident shareholders, particularly on substantial participations.
Thus, economic double taxation arises when the liquidation proceeds distributed to shareholders exceed the invested capital. The liquidation surpluses are taxed in the hands of the company and again on the shareholders when distributed to them. This double taxation could be avoided if the liquidation surpluses are tax-exempt.
Juridical double taxation may also occur if the surpluses are treated as dividends in the source State and taxed as capital gains in the State of residence. This double taxation is mitigated in some countries by the grant of exemption or tax credit, or a reduction in the tax rate or tax base.
Liquidation losses occur when the realization is less than the liabilities of the liquidated company. In such situations, the loss is borne ultimately by the shareholders. Some countries allow these losses to be deducted from the capital gains on similar investments or from other capital gains. Again, liquidation losses incurred by shareholders should be deductible if similar surpluses are taxable.
4. Cross-border Leasing:
Cross-border leasing is often used for financing the purchase of high-value assets (also called “big ticket” leasing). It provides the lessee with tax-efficient financing to acquire an asset through a lessor, who effectively passes the tax benefits on the leased asset to the lessee in reduced rentals.
These tax benefits are derived from the tax losses generated by depreciation tax deductions granted on the leased asset in his State of residence to the lessor as the legal owner of the asset.
The tax losses are usually enhanced further through additional non-recourse debt. For example, the lessor may incur tax deductible interest expense to finance the leased asset through a mortgage and assignment of the lease receivables.
In such leasing transactions, usually a fiscally transparent entity (e.g. limited partnership) is formed by a financial institution as a special purpose vehicle (SPV) to own the equipment and to act as the lessor.
A small group of investors as limited partners provide the equity and the rest is financed through debt. The tax losses due to depreciation allowances and interest expense are shared by the investors, usually for a fee payable to the lessor, for offset against their own current tax liabilities.
The lessor applies the fee to cover his own costs and profit margin, and also reduce the lease rentals. As a financing lease, the lessee is responsible for all operating costs and expenses and may also have a purchase option over the equipment at the end of the lease. The lessee claims deductions for the lease payments in his home country.
Usually, but not always, the leasing cost to the lessee is greater than direct ownership if the lessee can use the tax losses as effectively as the lessor. The principal reason for using a lease rather than purchase is the lessee’s inability to take advantage of these benefits fully on a current basis.
Leasing permits a change in the legal ownership of a property to another entity that can then use them currently and pass the benefits to the lessee in lower lease rentals. It separates the user from the owner and allows current use of the available tax losses that would otherwise have to be carried forward.
Leasing structures are largely tax-driven. The tax deferral due to timing differences in book and tax depreciation on the asset creates a current tax loss benefit and defers the tax payable to a future date. They allow the lessor to exploit the time value of these tax losses.
These tax losses are used by the lessor (a) to defer the tax on the lease income to a later year (i.e. deferred tax liability), and also (b) to offset against the current tax payable on other taxable income (own and investors). As the overall tax liability over the life of the asset remains unchanged the timing of the tax losses is the relevant tax benefit in leasing.
In domestic lease transactions, the lessee obtains the benefit of the time value of money as reduced lease rentals. In cross-border leasing, it is possible to exploit the differences under the tax laws of various countries and maximize these allowances through careful choice of the lessor jurisdiction.
The tax consequences of a lease largely depend on the characterization of the transaction as a sale, finance lease or operating lease. In a finance lease, some countries grant the depreciation allowance to the lessee as the economic owner, while others grant it to the lessor as the legal owner.
Examples of tax-driven structures for cross-border leasing include:
(i) Double-dip Leasing:
A lease may be either a property rental (“operating lease”) or a conditional sale (“finance lease”). While some countries follow the form and grant the tax depreciation to the lessor as the legal owner, others look at the substance and grant it to the lessee as the economic owner.
In the latter case, the lease is considered as a financial transaction involving a sale to the lessee, subject to certain conditions. These qualification conflicts create opportunities for tax arbitrage and allow both the lessor and the lessee to claim simultaneous depreciation deductions.
(ii) Triple-dip Leasing:
A slightly modified form is a triple-dip leasing with a two-tier structure. It involves a cross-border sublease in an intermediary jurisdiction as a sublessor. The lessee as well as the sublessor qualifies for depreciation allowances in their own jurisdiction based on economic ownership while the lessor claims them as the legal owner in its jurisdiction.
(iii) Leveraged Leasing:
This type of lease is a finance lease with a high debt-equity component (typically 80% debt). The lessor purchases the asset with substantial loans from an outside lender, who provides non-recourse finance.
This loan leverages the lessor’s ability to lease assets valued at more than his equity capital and also claim higher depreciation on the full capital cost of the asset. The loan interest also creates additional tax-deductible expense for the lessor.
The tax benefits are often further increased through “back-loading” or payment of the bulk of the lease rentals (e.g. uneven lease rentals) in the later years of the lease. Leveraged leasing enables the lessor to claim higher tax benefits with a small capital investment and pass them to the lessee as lower lease rentals than available under a direct lease or other forms of non-recourse financing.
(iv) Sale and Leaseback:
The owner sells the asset and then leases it back. Such transactions may be undertaken for commercial reasons, for example to improve working capital, or for just obtaining a tax advantage. The lessee retains the economic ownership while the lessor has legal ownership.
The lessor claims the tax depreciation while the lessee now receives a tax deduction for the lease rental payments. The benefit of the deferred tax from depreciation allowances available to the lessor is usually shared with the lessee in lower lease rentals.
(v) Tax Sparing Leasing:
Several developing countries have tax sparing provisions in their treaties to reduce withholding taxes. This structure makes use of the tax sparing provisions in treaties. For example, the lease rental payments may not be subject to withholding tax in the host State but qualify for tax sparing credit in the home State under the treaty. (Example: Netherlands-China treaty).
(vi) Defeasance Leasing:
In defeasance leasing the lease payments are pre-funded or “defeased” by the lessee through an upfront payment of an amount equal to the present value of the lease installments to a defeasance bank.
The defeasance banker assumes the responsibility to pay future lease rental obligations in consideration for the upfront payment and also acts as a lender to the lessor in a leveraged-lease transaction.
The loan is not technically repaid but the defeasance provides a continuous source of cash payments in lieu of debt service payments. Lease payments through a defeasance entity in another jurisdiction may avoid or reduce withholding tax and currency risk exposure.
Thus, tax planning in cross-border leasing for the lessor usually involves:
a. Higher tax depreciation on leased assets granted to the lessor which can be either used to offset other taxable profits or passed to the lessee in lower lease rentals.
b. Ability to claim double depreciation deductions (also called double dip) in both the country of the lessor and the lessee due to differing characterization in the two States.
c. Avail of benefits such as lower or nil withholding tax on lease payments or tax sparing credits under tax treaties.
d. Transfer of tax advantages by the lessor to equity investors through the use of fiscally transparent entities, e.g., partnerships.
e. Provide additional tax deductions by increasing the lessor’s capacity to lease (e.g. leveraged leases.
f. Avoid specific restrictions or anti-avoidance provisions through the use of intermediary jurisdictions.
Tax planning may also be necessary in the State of the lessee. If the leased asset is located in the lessee’s home country there may be tax exposure for the lessor in the source State. For example, the leased asset may be deemed as a permanent establishment of the lessor and taxable in the source State. There may also be withholding taxes due on the lease and interest payments.
5. Foreign Direct Investment:
Foreign direct investment (FDI) is defined as “investment made to acquire a lasting interest in an enterprise operating in an economic environment other than that of the investor, the investor’s purpose being to have an effective voice in the management of the company”.
Investment can be either portfolio investment or direct investment. Whereas portfolio investment refers to passive investments in securities or shares, direct investment relates to acquisition of shares adequate to actively manage or control the entity, (i.e. substantial participation in the total shareholding).
From a tax viewpoint, what is portfolio investment and what is direct investment varies widely under domestic laws. Controlling interest would normally envisage more than 50% equity or voting rights in an entity. In many countries, a minimum shareholding of 25% (or even as low as 10%) is regarded as a substantial holding or participation to qualify as direct investment.
Both types of investments require tax planning but the methods used differ. Generally, countries provide tax incentives to encourage inbound FDI. They are also subject to different tax rules in the home country, particularly on the taxation of dividend income and the application of anti-avoidance rules.
For example, the dividends, and often the related capital gains, are either tax-exempt or eligible for indirect foreign tax credit under the participation exemption rules. They may, however, be subject to anti-avoidance provisions such as controlled foreign corporation and transfer pricing rules.
The importance of taxation on FDI also varies with whether the investment is made abroad solely to access the local market or for sale in export markets. In the former case, a low-taxed country helps to achieve higher post-tax return on profit remittances to the home investor.
Export-based activities are more affected by tax considerations as they are influenced by the prices of the exported goods or services in other markets. Various studies in the past have suggested that while the decision to invest abroad was usually taken on purely commercial factors, the choice of the country to invest was affected by tax considerations.
Thus, tax plays a significant role in today’s globalised world of business activities. Often, what is relevant to the investors is the after-tax return from the investment in the host country.
Multinationals prefer to invest, directly or indirectly, in countries that provide tax incentives and tax treaty benefits and have minimal tax compliance costs because of uncertainties, ambiguities, too-frequent legal changes, inconsistent interpretations, corrupt tax officials and high penalties. These factors also affect the level of profits reinvested in a foreign operation.
Business process outsourcing of labour-intensive functions to low-cost countries has emerged as a major FDI activity in recent years. Manufacturing is no longer a national activity; international competition encourages global sourcing from several countries with final assembly probably in a third country and sales perhaps in another country.
Similarly, services can be outsourced and financial markets are now much more integrated worldwide. There is a need to keep costs to a minimum. Tax is a cost and like all costs must be minimized to enhance the operating results and the investment returns.
Structuring Foreign Investment:
Foreign direct investment may be made either by injecting fresh capital (equity or loan) through an initial purchase of assets or shares or by reinvesting profits earned overseas.The investment may be in a new (or “Greenfield”) venture or an existing enterprise involving an acquisition, merger, joint venture or a business alliance.
Besides capital investment, it may include other profit-making activities such as licensing of technology, captive supplier or customer contractual relationships or provision of management and operational skills and systems.
Acquisition of an existing enterprise saves time taken in start-up operations of a new venture but can be expensive. An acquisition involves a purchase of either the shares or assets of the acquired company. A wholly-owned or controlled acquisition can be liquidated and converted into a branch, if permitted by the host country.
In a merger, one of the companies loses its identity and becomes a branch or permanent establishment of the other company. The foreign shareholders receive shares in the merged company. As mentioned earlier, true mergers between a domestic and foreign company are rare.
Joint venture loosely describes a company with equal equity held by two investors either in one of their countries or in a third country. There are also contractual joint ventures that are similar to a partnership. Tax issues affecting them depend on whether they are a separate taxable entity (non-transparent) or taxed like a fiscally transparent partnership.
In the latter case, they may be taxed as a branch or a permanent establishment of the foreign investor. It is also possible for an entity to be a legal person and be taxed as a transparent entity (e.g. European Economic Interest Grouping or EEIG) and vice versa.
The taxation of foreign profits in the host country also influences the legal structure of a multinational or multidivisional organization. The overseas activities may be conducted either through branches or subsidiaries or a combination. They may be only branches or subsidiaries, or subsidiaries with foreign branches.
These entities may be either owned directly by the parent company or, more often, held through holding companies in each country or in a third country. The choice depends on the rates of tax, how foreign income is taxed in each country and how double tax is relieved.
Tax considerations may affect the choice between a subsidiary and a branch. A foreign branch has no separate legal personality other than as part of the head office. Therefore, there is usually no withholding tax on profit remittances to the head office, unless a branch tax applies.
They key tax issues relate to the rules on attribution of income and expenses of the company to the branch. These rules are usually governed by domestic tax law and practices in the state of the branch and vary widely. A branch is generally preferable in the start-up loss-making years of operation with a conversion to a subsidiary when profitable.
Financing Foreign Investment:
According to the Ruding Committee Report, taxation is a major factor in financing decisions affecting foreign investments.
Some of the financing questions include:
(i) Source of finance:
They can be financed either by a loan from the parent company or by local borrowings. The parent company may again use retained earnings or borrow to finance the investment abroad. The local financing may be arranged by the investor either through a local branch or though a subsidiary.
(ii) Form of investment:
The financing may be used to buy shares or the underlying assets.
A parent investor may invest directly in foreign shares or assets or acquire them through a subsidiary or branch in the host country.
Each of these choices has different tax implications. In case of direct share purchase by the investor with a loan, he will be able to offset his loan expense only against dividend income when received from the host country.
To offset the interest cost against the related future income flows derived from the acquired shares currently, usually requires a tax consolidation or merger with a holding company in the host country. This problem does not arise when assets are purchased.
A key consideration in planning for overseas financing is the desire to maximize the debt and minimize the equity in the total investment. As debt interest is tax-deductible and dividends on capital are not, it helps to reduce the taxable profits.
Ideally, an investor may wish to finance wholly with debt, but this approach may not be acceptable under the thin capitalization rules. A portion of the interest may be disallowed and deemed as a constructive dividend on notional capital.
A very high debt-equity ratio may also not be tax efficient if there are insufficient taxable profits and the time-period for loss carry-forwards are restricted. Additional considerations may apply in a joint venture between foreign and local investors. Both of them may have different tax and non-tax objectives.
Besides holding companies in the host country for tax consolidation, financing structures for foreign direct investment may also use holding companies in an intermediary country. A wholly-owned subsidiary in a third country may hold the shares in the subsidiary or have a branch in the host country.
Such structures can help to reduce host country taxation, accumulate income overseas and reduce tax on profits repatriated. They may also benefit from lower withholding taxes through treaty shopping. To be effective, the savings through the use of the third country entity must exceed their tax and non-tax cost.
Popular jurisdictions tend to be countries that allow the use of their treaty network to reduce inbound withholding taxes, impose little or no taxes on income received and do not levy withholding tax on outbound payments. Several onshore countries offer special tax regimes for holding companies.
Direct Investment in Developing Countries:
Many developing countries suffer from political and/or economic instability. Despite their high-risk profile, the primary attraction for cross-border investment in these countries is often the access to their potentially large consumer market or as a low-cost sourcing base, for labour and materials, and not tax.
Nevertheless, tax plays a significant role once an investment decision is taken. Foreign investors must manage both tax and non-tax risk factors.
Some tax planning suggestions include:
a. Operate in the host country without a permanent establishment or taxable presence (assuming there is a tax treaty). It may also be possible to consider local contract or toll manufacturing arrangements. Transfer pricing rules may allow risk-free global operations for both manufacturing and distribution through appropriate structures.
b. Keep the profit base low through legitimate profit extraction, such as management fees, etc. to minimize the local tax liability. Management fees are useful as they are paid out of pre-tax profits, often gross without any withholding tax. A cost-plus basis for management fee may be acceptable.
c. Use intermediary companies to reduce the dividend withholding tax through treaty shopping, and set up offshore trusts to hold the investments. They may hold investments either directly or through an overseas holding company, and also assist in raising finance.
d. Ensure full use of allowances and incentives. Many developing countries provide a wide range of incentives. However, not all of them may be helpful. For example, tax holidays are useful if the operations are likely to be profitable within the incentive period, tax sparing credits are useful if dividends are to be remitted, and cash grants and other incentives are worthwhile in start-up situations. Some countries provide tax incentives to encourage reinvestment of profits. They may be used to finance further expansion in the same or another country.
The key non-tax factors relate to the political, economic and management issues. Sovereign or country risks can be mitigated through bilateral investment protection agreements (IPPA). There are over 1300 IPPAs today between governments of more than 140 countries.
These agreements are similar to tax treaties but with safeguards for adverse exchange control risks (e.g. frozen funds) or seizure of property without compensation. These agreements also provide for international arbitration in case of disputes and contain the “most favoured nation” provisions on investments.
Exposed assets can also be covered under insurance for political risks or guarantee schemes, such as the Multilateral Investment Guarantee Agency (“MIGA”) of the World Bank and Overseas Private Investment Corporation (“OPIC”) of the US government.
In case of exchange control risks, local financing is preferable with the external investment kept at a minimum. It is advisable to plan a short investment payback period and arrange to repatriate profits quickly.
Financing techniques may also be used to keep external capital investment low through, for example, back-to-back loans arranged with a local branch of an international bank in local currency. It may also be possible to swap funds on bank accounts between incoming and outgoing investors. Investors should also examine their ability to use blocked currency finance locally.
Local partners in joint ventures may be useful, particularly in the initial stages of the business, to provide local contacts and established business relationships, and local business know-how. They may also provide a possible exit route through the subsequent sale to them.
If long-term presence is intended, they could become an additional burden, particularly if the foreign partner provides all the capital, technology and management or wishes to integrate the operations with his global organization.
The OECD Model treaty is based primarily on residence-based taxation, with reciprocal concessions between treaty partners assuming similar income and capital flows. It may not usually favour transactions undertaken with developing countries.
The UN MC addresses this disparity through greater emphasis on source taxation. As the UN Model treaty is often applicable to them, tax treaties with developing countries may not be as favourable in tax planning for investors from developed countries.