Taxation of Multinational Corporations


  1. Where are MNCs?
  Their offices are located in major international cities, metropolitan areas, and port cities to meet local consumer demands and to acquire resources such as materials and laborers.
Metropolitan areas

Green Gate, Long Street (Gdansk)

Dutch (multinational company) buildings in Long Street, Gdansk, Poland. These were destroyed by Germans during WWII, but were meticoulously rebuilt in accordance with the blue print after the war.

A night scene of multinational firms at Victoria harbor in Hong Kong.

  Multinational firms tend to be capital-intensive and require high-skilled workers. Universities are an important source of high-skilled workers.

 

  2. US Tax Policy towards MNCs
   Operating in many countries, MNCs are subject to multiple tax jurisdictions, i.e., they may be forced to pay taxes to several countries. National tax systems are exceedingly complex and differ between countries.

Differences among national income tax systems affect the decisions of managers of MNCs, regarding the location of subsidiaries, financing, and the transfer prices (the prices of products and assets transferred between various units of MNCs)

It is argued that American firms are moving their factories to Mexico, because of high US wages, high corporate tax rates, and currency manipulations of other countries.

 Overlapping ⇒ double taxation

 Multiple Tax Jurisdictions create two problems, overlapping and underlapping jurisdictions. When overlapping occurs, two or more governments claim tax jurisdictions over the same income of an MNC. The overlapping may result in double taxation.

 Underlapping ⇒ tax avoidance  Conversely, when underlapping occurs, an MNC falls between tax jurisdictions and escape taxation. Underlapping encourages tax avoidance.
Territorial Tax system National governments may claim territorial jurisdiction or national tax jurisdiction or both.

TT: The government taxes business income that is earned on the national territory.

  • Any business income earned on the US territory is subject to income tax, regardless of whether the business is owned by foreigners.
  • any foreign source income earned by the nationals are exempt from taxation. This approach is used by most European countries (e.g., France, Italy, Netherlands. 34 countries)
  • Tax comptition: Since countries have different tax rates, multinational companies choose to invest in low-tax countries. Governments may compete to attract multinational enterprises by offering them lower tax rates and other incentives. This is called tax competition. Since high-tax countries lose lucrative businesses, they want to harmonize tax rates, especially within a free trade area or customs union (e.g., European Community). For more information on this subject, see Daniel Mitchell (Heritage Foundation article on tax competition).
  • What a $17 billion Samsung Investment looks like (reconsidering)
  • Lowering corporate tax rate ⇒(i) worsens income inequality, i.e., the rich gets richer, but (ii) creates more jobs and improves income inequality, i.e., the poor gets richer.
  • CHIPS act: cough up 75% of chip subsidies on foreign firms building factories in the US
  • (Apple freezes plan to buy memory chips from YMTC)

Q: Is Apple an American or Chinese firm? 98% of iPhones are produced in China.

  • Apple is an American firm because its CEO, Tim Cook, is an American?

Samsung is expected to hire 2000 high-tech jobs in a chip factory in Taylor, Texas. Samsung is considered a foreign firm, being required to cough up chip subsidies.

  • Chip clusters are needed. Designers (Intel, Samsung) and Foundry (TSMC, Samsung, Micron) need to be in the same area (to expedite communication between the two)
  • The first prototype chips are handcrafted and the foundy ships the chip to the designer.
  • The designer sort out problems with low yield (% of good chips: initially low = 10%) and suggesting improvements. FedEx the results to the foundry. These gradual steps are repeated until the yield rate is 80 - 90%, and the chips are marketable. To reduce time and costs, the designer and the foundry need to be in close proximity, hence, a cluster is needed in areas with no earthquakes, tsunami, or political uncertainty.
National Tax system NT: Both domestic and foreign source income of national companies is subject to income tax. US government taxes both domestic and foreign source incomes of US MNCs.

Remark: Most governments that adopt NT system also claim Territorial Tax jurisdiction. This creates the problem of double taxation.

Rutger Bregman

(unaired interview with Tucker Carlson)

income tax rate for the super-rich "should be 90%."

France had imposed the income tax rate of 75% for €1 million-plus earners. Said bye to the supertax after a few years in 2015.

US income tax rate

Federal income tax: 13.5%
State and local income tax: 10%
Medicare tax: 3.3% + property tax (the rich pay).

On average Americans pay 30% of their income as tax (including state and local tax + real estate tax).

Japan's Income tax rate = about 55% plus 10% consumption tax.

No wonder Japan's economy stopped growing for 25 years since 1992.

   

 

  3. US Taxation of Foreign Source Income
 NT 1. In general the US government does not distinguish between income earned abroad and income earned at home (NTJ).

However, to avoid double taxation, the US government gives credit to MNEs headquartered in the US for the amount of tax paid to foreign governments.

 Burke-Hartke Bill

2. Foreign Trade and Investment Act of 1972 (Burke-Hartke Bill) was defeated.

US federal income tax rate is 35%, but the average state and local tax rate is about 4%. The combined US corporate tax rate is thus 39%. According to this plan, foreign taxes would be treated as business expenses. For example,

Assume: t = 40%, t* = 30% (Spain)

Pretax profit = $1,000

MNC's profit after foreign tax = 1,000 - 300 = 700

If foreign tax is treated as business expense, then

MNC's tax to IRS = 700 × 40% = 280.

Total taxes = 300 + 280 = 580. (45% more)

(To raise more revenue, this idea is being discussed recently.)

 Current Method
Taxes to foreign government = 1000 × 30% = 300

US taxes = 1000 × 40% = 400

but foreign tax credit = 300

Net tax to IRS = 400 - 300 = 100.

Total taxes = 300 + 100 = 400.

  It is essential to have a low tax rate to attract FDI. Foreign investers may invest in Canada or Mexico, rather than in the US.
 corporate tax rates

Japan = 40.69% (2011) →30.86% (2016)
China = 33%
Germany =38.31%
France = 33.33% (individual tax: 41%. Supertax: after €1 million ⇒ 75%, ended in 2014)
Finland = 26%
Hong Kong = 17.5%
Macau = 12%
US = 39% (max individual tax: 56%)
Canada = 26%, Mexico = 30%
Russia = 13%

0-25%: 75 countries

25-30%: 43 countries

30-35%: 28 countries

>35%: 3 countries

US Marginal corporate tax rate : 35% > 34% (France) > 22.5% (world average): cut from 35% to 21% since Feb 2018.)


 
 
  4. Transfer Pricing
 Intrafirm trade Transfer prices are the prices paid for imports/exports between the headquarters (HQ) and subsidiaries. 
 Why manipulate TP?

MNCs manipulate prices between the HQ and the subsidiaries so as to realize more profits. Profits may be the highest in the countries with lowest tax rates.

Purpose: to minimize the total tax a multinational firm pays.

MNCs try to reduce their overall tax burden. An MNC reports most of its profits in a low-tax country, even though the actual profits are earned in a high-tax country.

 Example  tp = tax rate in the parent country

th = tax rate in the host country

If tp > th, then lower export prices to the subsidiary in the host country, and raise import prices from the subsidiary. ⇒ lower tax.

Transfer prices affect MNC's profit

China's investment in EU rose from $6 billion in 2010 to $55 billion in 2014.

MNC's Goal: report maximum profit in the country with the lowest tax rate.

In High-Tax countries: To reduce MNC profits,

(i) lower selling prices, and

(ii) raise buying prices

In Low Tax countries, do the opposite

Total tax = $135 ($7000 × 15%)

Thus, a multinational company's overall tax could be paid at the lowest tax rate of all countries in which it operates.

Abuses in pricing across national borders are illegal (if they can be proved). MNCs are required to set prices at "arms length" (set prices as if they are unrelated).

IRS argued that Toyota Inc. of Japan had systematically overcharged its US subsidiary for years on most of trucks, automobiles and parts sold to the US (Martz and Thomas, 1991).

Because of abuses in transfer pricing, taxable profits were shifted to Japan. The settlement Toyota offered to IRS reportedly approached $1 billion. 

   

  5. Policies toward FDI
  National Defense Authorization Act 2019 limits technology transfers to other countries.
   

  6. Taxation and Gains from Factor Mobility
 why invest overseas

US firms invest overseas because the returns are higher there.

(private gains)

 National gains  natonal gains can be higher when investment stays home.
Tax Wars to attract FDI  Assume both countries have the same corporate tax rates = 40%

                 US                  Canada
Pretax profits   10%                 12%
Tax               4%                  4.8%
Net to investors  6%                  7.2%
US Gains         10% (4+6)            7.2%

US Gains from domestic investment = 10% (= 4% + 6%) because tax revenues can be used to build US infrastructure.

US corporate tax rate was the second highest after Japan (40.69% in 2011, but declined to 30.86% in 2016), and is a loser in international tax wars /tax competition. ⇒ Outbound FDI > Inward FDI.

Multinationals may retain profits for investment purposes, and need not repatriate profits to the US.

Total Gains from foreign investment = 7.2% < 10% (= Gains from domestic investment, because US government gets nothing). The tax revenue which could have been used to build US highways would be used by Canadian government to build their highways.

Effects of lowering corporat tax rate: (i) increase inward FDI and decrease outbound FDI, (ii) increase repatriation of foreign profits. (Foreign profits of US multinationals are not subject to US income tax if they are parked or reinvested overseas.)

   

 
  12. FDI Shares
  Stock of outward FDI (The Economist)
1914

(when WWI broke out)

Britain 45%

US 18%

Japan 2%

1967 US 50%, Britain 14%, Japan 2%
2009 US 23%, Britain 9%, China 6% (and rising to 10% in 2010)
US FDI stock

Inward FDI: $2.8 trillion (2000), $3.5 trillion (2011)

Outward FDI:$2.7 trillion (2000), $4.5 trillion (2011). This might be due to the fact that US corporate tax rate is higher than the world.)

source: Lucyna Kornecki, Managerial issues in Finance and Banking: A strategic approach to competitiveness, Hacioglu, Ü, Dinçer (eds.)