This document discusses international taxation for multinational corporations. It covers key topics like how taxes affect investment decisions, different tax rates and types of taxes across countries, and strategies to minimize double taxation. The objective for multinational companies is to minimize worldwide taxes by taking advantage of differences in tax laws and rates between countries where they operate.

1. INTRODUCTION
Taxes paid to governments are one of the most significant costs incurred by business enterprises.
Taxes reduce net profits as well as cash flow. Well-managed companies attempt to minimize the
taxes they pay while making sure they are in compliance with applicable tax laws. For a
multinational corporation (MNC) that pays taxes in more than one country, the objective is to
minimize taxes worldwide. The achievement of this objective requires expertise in the tax law of
each foreign country in which the corporation operates. Knowledge of how the domestic country
taxes the profits earned in foreign countries is also of great importance. MNCs make a number of
very important decisions in which taxation is an important variable. For example, tax issues are
important in deciding (1) where to locate a foreign operation, (2) what legal form the operation
should take, and (3) how the operation will be financed.
Investment Location Decision
The decision to make a foreign investment is based on forecasts of after-tax profit and cash flows.
Because effective tax rates vary across countries, after-tax returns from competing investment
locations could vary. The decision of whether to place an operation in either Spain or Portugal, for
example, could be affected by differences in the tax systems in those two countries.
Legal Form of Operation
A foreign operation of an MNC is organized legally either as a branch of the MNC or as a subsidiary, in
which case the operation is incorporated in the foreign country. Some countries tax foreign branch income
differently from foreign subsidiary income. The different tax treatment for branches and subsidiaries could
result in one legal form being preferable to the other because of the impact on profits and cash flows.
Method of Financing

2. MNCs can finance their foreign operations by making capital contributions (equity) or through loans
(debt). Cash flows generated by a foreign operation can be repatriated back to the MNC by making either
dividend payments (on equity financing) or interest payments (on debt financing). Countries often impose
a special (withholding) tax on dividend and interest payments made to foreigners. Withholding tax rates
within a country can differ by type of payment. When this is the case, the MNC may wish to use more of
one type of financing than the other because of the positive impact on cash flows back to the MNC. These
examples demonstrate the importance of developing an expertise in international taxation for the
management of an MNC. It is impossible (and unnecessary) for every manager of an MNC to become a
true expert in international taxation. However, all managers should be familiar with the major issues in
international taxation so that they know when it might be necessary to call on the experts to help make a
decision.
TYPES OF TAXES AND TAX RATES
Corporations are subject to many different types of taxes, including property taxes, payroll taxes, and
excise taxes. While it is important for managers of MNCs to be knowledgeable about these taxes, we focus
on taxes on profit. The two major types of taxes imposed on profits earned by companies engaged in
international business are (1) corporate income taxes and (2) withholding taxes.
Income Taxes
Most, but not all, national governments impose a direct tax on business income. Exhibit 11.1 shows
that national corporate income tax rates vary substantially across countries. The corporate income
tax rate in most countries is between 20 and 35 percent. Differences in corporate tax rates across
countries provide MNCs with a tax-planning opportunity as they decide where to locate foreign
operations. In making this decision, MNCs must be careful to consider both national and local
taxes in their analysis. In some countries, local governments impose a separate tax.

3. on business income in addition to that levied by the national government. For example, the national
tax rate in Switzerland is 8.5 percent, but additional local taxes range anywhere from 6 percent to
33 percent. A company located in Zurich can expect to pay an effective tax rate of 21.17 percent
to local and federal governments. Corporate income tax rates imposed by individual states in the
United States vary from 0 percent (e.g., South Dakota) to as high as 12 percent (Iowa). In a few
countries, corporate income taxes can vary according to the type of activity in which a company
is engaged or the nationality of the company’s owners. As examples, the rate of national income
tax in France is reduced to 15 percent on income generated from certain intellectual property rights,
in Malaysia a special 5 percent rate applies to corporations involved in qualified insurance
businesses, and India taxes foreign companies at a 10 percent higher rate than domestic companies.
Tax Havens
There are a number of tax jurisdictions with abnormally low corporate income tax rates (or no
corporate income tax at all) that companies and individuals have found useful in minimizing their
worldwide income taxes. These tax jurisdictions, known as tax havens, include the Bahamas and
the Isle of Man, which have no corporate income tax, and Liechtenstein, which has tax rates
ranging from 7.5 percent to 15 percent. A company involved in international business might find
it beneficial to establish an operation in a tax haven to avoid paying taxes in one or more countries
in sawir
which the company operates. For example, assume a Brazilian company manufactures a product
for $70 per unit that it exports to a customer in Mexico at a sales price of $100 per unit. The $30
of profit earned on each unit is subject to the Brazilian corporate tax rate of 34 percent. The
Brazilian manufacturer could take advantage of the fact that there is no corporate income tax in
the Bahamas by establishing a sales subsidiary there that it uses as a conduit for export sales. The

4. Brazilian parent company would then sell the product to its Bahamian sales subsidiary at a price
of, say, $80 per unit, and the Bahamian sales subsidiary would turn around and sell the product to
the customer in Mexico at $100 per unit. In this way, only $10 of the total profit is earned in Brazil
and subject to Brazilian income tax; $20 of the $30 total profit is recorded in the Bahamas and is
therefore not taxed.
The Organization for Economic Cooperation and Development (OECD) has established guidelines
for tax regimes to ensure that they cannot be used to avoid taxation in other countries. Because
the OECD lack enforcement power, its member countries must put pressure on tax havens in order
for them to change their tax regimes. Exhibit 11.2 provides a list of criteria the OECD uses to
identify tax havens and the countries meeting these criteria in 2004. Most of these countries have
expressed a willingness to change their tax regimes to be removed from the OECD list and avoid
any possible defensive measures by its member nations. Sawir
Withholding Taxes
When a foreign citizen who invests in the shares of a U.S. company receives a dividend payment,
theoretically he or she should fi le a tax return with the U.S. Internal Revenue Service and pay
taxes on the dividend income. If the foreign investor does not fi le this tax return, the U.S.
government has no recourse for collecting the tax. To avoid this possibility, the United States (like
most other countries) will require the payer of the dividend (the U.S. company) to withhold some
amount of taxes and remit that amount to the U.S. government. This type of tax is referred to as a
withholding tax. The withholding tax rate on dividends in the United States is 30 percent. To see
how the withholding tax works, assume that International Business Machines Corporation (IBM),
a U.S.-based company, pays a $100 dividend to a stockholder in Brazil. Under U.S. withholding
tax rules, IBM would withhold $30 from the payment (which is sent to the U.S. Internal Revenue

5. Service) and the Brazilian stockholder would be issued a check in the amount of $70. Withholding
taxes are also imposed on payments made to foreign parent companies or foreign affiliated
companies. There are three types of payments typically subject to withholding tax: dividends,
interest, and royalties. Withholding tax rates vary across countries, and in some countries
withholding rates vary by type of payment or recipient. Exhibit 11.3 provides withholding rates
generally applicable in selected countries. In many cases, the rate listed will be different for some
subset of activity. For example, although the U.S. withholding rate on interest payments is
generally 30 percent, interest on bank deposits and on certain registered debt instruments (bonds)
is exempt (0 percent tax). In addition, many of the rates listed in Exhibit 11.3 vary with tax treaties
(discussed later in this chapter).
Tax-Planning Strategy
Differences in withholding rates on different types of payments in some countries provide an
opportunity to reduce taxes (increase cash flow) by altering the method of financing a foreign
operation. For example, a British company planning to establish a manufacturing facility in Austria
would prefer that future cash payments received from the Austrian subsidiary be in the form of
interest rather than dividends because of the lower withholding tax rate (0 percent on interest
versus 25 percent on dividends). This objective can be achieved by the British parent using a
combination of loan and equity investment in financing the Austrian subsidiary. For example,
rather than the British parent investing €10 million in equity to establish the Austrian operation,
€5 million is contributed in equity and €5 million is lent to the Austrian operation by the British
parent. Interest on the loan, which is a cash payment to the British parent, will be exempt from
Austrian withholding tax, whereas any dividends paid on the capital contribution will be taxed at
25 percent. Many countries have a lower rate of withholding tax on interest than on dividends. In

6. addition, interest payments are generally tax deductible, whereas dividend payments are not. Thus,
there is often an incentive for companies to finance their foreign operations with as much debt and
as little equity capital as possible. This is known as thin capitalization, and several countries have
set limits as to how thinly capitalized a company may be. For example, in France, interest paid to
a foreign parent will not be tax deductible for the amount of the loan that exceeds 150 percent of
equity capital. In other words, the ratio of debt to equity may not exceed 150 percent for tax
purposes. If equity capital is €1 million, any interest paid on loans exceeding €1.5 million will not
be tax deductible. Similarly, in Mexico, subsidiaries of foreign parents run the risk of having some
interest declared nondeductible when the debt-to-equity ratio exceeds 3 to 1.
Value-Added Tax
than the European Union, including Australia, Canada, China, Mexico, Nigeria, Turkey, and South
Africa. Many countries generate a significant amount of revenue through the use of a national
value-added tax (VAT). Standard VAT rates in the European Union, for example, range from a low
of 15 percent (Luxembourg) to a high of 27 percent (Hungary). 3 Value-added taxes are used in
lieu of a sales tax and are generally incorporated into the price of a product or service. This type
of tax is levied on the value added at each stage in the production or distribution of a product or
service. For example, if a Swedish forest products company sells lumber that it has harvested to a
Swedish wholesaler at a price of €100,000, it will pay a VAT to the Swedish government of €25,000
(€100,000 * 25%). When the Swedish wholesaler, in turn, sells the lumber to its customers for
€160,000, the wholesaler will pay a VAT of €15,000 (25% * €60,000 value added at the wholesale
stage). The VAT concept is commonly used in countries other Value-added taxes as well as other
indirect taxes (such as sales and payroll taxes) need to be considered in determining the total rate
of taxation to be paid in a country. Sawiir

7. TAX JURISDICTION
One of the most important issues in international taxation is determining which country has the
right to tax which income. In many cases, two countries will assert the right to tax the same income,
resulting in the problem of double taxation. For example, consider a Brazilian investor earning
dividends from an investment in IBM Corporation common stock. The United States might want
to tax this dividend because it was earned in the United States, and Brazil might want to tax the
dividend because it was earned by a resident of Brazil. This section discusses general concepts
used internationally in determining tax jurisdiction. Subsequent sections examine mechanisms
used for providing relief from double taxation.
Worldwide versus Territorial Approach
One tax jurisdiction issue is related to the taxation of income earned overseas, known as foreign
source income. There are two approaches taken on this issue:
1. Worldwide (nationality) approach. Under this approach, all income of a resident of a
country or a company incorporated in a country is taxed by that country regardless of where
the income is earned. In other words, foreign source income is taxed by the country of
residence. For example, Canada imposes a tax on dividend income earned by a Canadian
company from its subsidiary in Hong Kong, even though that income was earned outside
of Canada. Most countries exercise tax jurisdiction on the basis of nationality and impose
a tax on worldwide income
2. Territorial approach. Under this approach, only the income earned within the borders of the
country (domestic source income) is taxed. For example, the dividend income earned by a
resident of Venezuela from investments in U.S. stocks will not be taxed in Venezuela. Few

8. countries follow this approach, and the number is decreasing. South Africa, one of the few
countries using a territorial approach, moved to the worldwide basis of taxation beginning
in 2000. The most economically important country that continues to use a territorial
approach is France.
Source, Citizenship, and Residence
Regardless of the approach used in determining the scope of taxation, a second issue related to
jurisdiction is the basis for taxation. Countries generally use source, citizenship, residence, or
some combination of the three for determining jurisdictional authority.
Source of Income
In general, almost all countries assert the jurisdictional authority to tax income where it is
earned—in effect, at its source—regardless of the residence or citizenship of the recipient. An
example would be the United States taxing dividends paid by IBM Corporation to a
stockholder in Canada because the dividend income was earned in the United States.
Citizenship
Under the citizenship basis of taxation, citizens are taxed by their country of citizenship
regardless of where they reside or the source of the income being taxed. The United States is
unusual among countries in that its taxes on the basis of citizenship. Thus, a U.S. citizen who
lives and works overseas will be subject to U.S. income tax on his or her worldwide income
regardless of where the citizen earns that income or resides.
Residence

9. Under the residence approach, residents of a country are taxed by the country in which they
reside regardless of their citizenship or where the income was earned. For example, assume a
citizen of Singapore resides permanently in the United States and earns dividends from an
investment in the shares of a company in the United Kingdom. Taxing on the basis of residence,
this individual will be subject to taxation in the United States on his or her foreign source
income, even though he or she is a citizen of Singapore. The United States is one country that
taxes on the basis of residence. For tax purposes, a U.S. resident is any person who is a U.S.
permanent resident, as evidenced by holding a permanent resident permit issued by the
Immigration and Naturalization Service (the “green card” test), or is physically present in the
United States for 183 or more days in a year (physical presence test). Note that because the
United States levies taxes using a worldwide approach, the worldwide income of an individual
holding a U.S. permanent resident card is subject to U.S. taxation even if he or she is not
actually living in the United States.
Double Taxation
The combination of a worldwide approach to taxation and the various bases for taxation can
lead to overlapping tax jurisdictions that can in turn lead to double or even triple taxation. For
example, a U.S. citizen residing in Germany with investment income in Austria might be
expected to pay taxes on the investment income to the United States (on the basis of
citizenship), Germany (on the basis of residence), and Austria (on the basis of source). The
same is true for corporate taxpayers with foreign source income. The most common overlap of
jurisdictions for corporations is where the home country taxes on the basis of residence and
the country where the foreign branch or subsidiary is located taxes on the basis of source.
Without some relief, this could result in a tremendous tax burden for the parent company. For

10. example, income earned by the Japanese branch of a U.S. company would be taxed at the
effective Japanese corporate income tax rate of 41 percent and at the rate of 35 percent in the
United States, for an aggregate tax rate of 76 percent. The U.S. parent has only 24 percent of
the profit after income taxes. At that rate, there is a disincentive to establish operations
overseas. Without any relief from double taxation, all investment by the U.S. company would
remain at home in the United States, where income would be taxed only at the rate of 35
percent.
FOREIGN TAX CREDITS
Double taxation of income earned by foreign operations generally arises because the country
where the foreign operation is located taxes the income at its source and the parent company’s
home country taxes worldwide income on the basis of residence. To relieve the double taxation,
the question is, which country should give up its right to tax the income? The international
norm is that source should take precedence over residence in determining tax jurisdiction. In
that case, it will be up to the parent company’s home country to eliminate the double taxation.
This can be accomplished in several ways. One way would be to exempt foreign source income
from taxation—in effect, to adopt a territorial approach to taxation. A second approach would
be to allow the parent company to deduct the taxes paid to the foreign government from its
taxable income. A third would be to provide the parent company with a credit for taxes paid to
the foreign government. Some countries have decided to deal with double taxation through the
first option. The mechanics of applying this option are fairly straightforward; foreign source
income simply is not included in the parent’s tax declaration. Most countries, in contrast, have
decided to use the second and third options. As a point of reference, the specific U.S. tax rules
related to foreign tax credits and deductions are described here.

11. Credit versus Deduction
For U.S. tax purposes, U.S. companies are allowed to either (1) deduct all foreign taxes paid
or (2) take a credit for foreign income taxes paid. Income taxes include withholding taxes, as
discussed above, but exclude sales, excise, and other types of taxes not based on income.
Unless taxes other than income taxes are substantial, it is more advantageous for a company to
take the foreign tax credit rather than a tax deduction.
Example: Deduction for Foreign Taxes Paid versus Foreign Tax Credit Assume ASD
Company’s foreign branch earns income before income taxes of $100,000. Income taxes paid
to the foreign government are $30,000 (30 percent). Sales and other taxes paid to the foreign
government are $10,000. ASD Company must include the $100,000 of foreign branch income
in its U.S. tax return in calculating U.S. taxable income. The options of taking a deduction or
tax credit are as follows:
ASD Company’s U.S. Tax Return
Deduction Credit
Foreign source income . . . . . . . . . . . . . . . . . . . . . . . . $100,000 $100,000
Deduction for all foreign taxes paid . . . . . . . . . . . . . . . −40,000 0
U.S. taxable income . . . . . . . . . . . . . . . . . . . . . . . .. $ 60,000 $100,000
U.S. income tax before credit (35%) . . . . . . . . . . . . . . . . . $ 21,000 $ 35,000
Foreign tax credit (for income taxes paid) . . . . . . . . .. 0 −30,000
Net U.S. tax liability . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 21,000 $ 5,000
Calculation of Foreign Tax Credit

12. The rules governing the calculation of the foreign tax credit (FTC) in the United States are rather
complex. In general, the FTC allowed is equal to the lower of (1) the actual taxes paid to the foreign
government, or (2) the amount of taxes that would have been paid if the income had been earned
in the United States. This latter amount, in many cases, can be calculated by multiplying the
amount of foreign source income by the effective U.S. tax rate on worldwide taxable income. This
is known as the overall FTC limitation because the United States will not allow a foreign tax credit
greater than the amount of taxes that would have been paid in the United States. To allow an FTC
greater than the amount of taxes that would have been paid in the United States would require the
U.S. government to refund U.S. companies for higher taxes paid in foreign countries. More
formally, the overall FTC limitation is calculated as follow
Overall FTC limitation= Foreign source taxable income/ Worldwide taxable income* U.S. taxes
before FTC
Example: Calculation of Foreign Tax Credit for Branches
Assume that two different U.S.-based companies have foreign branches. Alpha Company has a
branch in Country A, and Zeta Company has a branch in Country Z. The amount of income before
tax earned by each foreign branch and the amount of income tax paid to the local government is
as follows:
Alpha Company Branch in A Zeta Company Branch in Z
Income before taxes …...... $100,000 $100,000
Income tax paid ……… $ 25,000 (25%) $ 37,000 (37%)
Both Alpha and Zeta will report $100,000 of foreign branch income on their U.S. tax return, and
each will determine a U.S. tax liability before FTC of $35,000. For both companies, $35,000 is the

13. amount of U.S. taxes that would have been paid if the foreign branch income had been earned in
the United States. The overall FTC limitation is $35,000 for both companies.
Alpha compares the income tax of $25,000 paid to the government of CountryAwith the limitation
of $35,000 and will be allowed an FTC of $25,000, the lesser of the two. Zeta compares actual
taxes of $37,000 paid to the government of Country Z with the limitation of $35,000 and will be
allowed an FTC of $35,000, the lesser of the two. The U.S. income tax return related to foreign
branch income for Alpha and Zeta reflects the following.
U.S. Tax Return
Alpha Zeta
U.S. taxable income . . . . . . . . . . . . $100,000 $100,000
U.S. tax before FTC (35%) ………… $ 35,000 $ 35,000
FTC………………………………………. .. . . ….. 25,000 35,000
Net U.S. tax liability . . . . . . . . . . . . . $ 10,000 $ 0
CONTROLLED FOREIGN CORPORATIONS
To crack down on the use of tax havens by U.S. companies to avoid paying U.S. taxes, the U.S.
Congress created controlled foreign corporation (CFC) rules in 1962. 8 A CFC is any foreign
corporation in which U.S. shareholders hold more than 50 percent of the combined voting power
or fair market value of the stock. Only those U.S. taxpayers (corporations, citizens, or tax residents)
directly or indirectly owning 10 percent or more of the stock are considered U.S. shareholders in
determining whether the 50 percent threshold is met. All majority-owned foreign subsidiaries of
U.S.-based companies are CFCs. As noted earlier in this chapter, the United States generally defers
taxation of income earned by a foreign investment until a dividend is received by the U.S. investor.

14. For CFCs, however, there is no deferral of U.S. taxation on so-called Subpart F income. Instead,
Subpart F income is taxed currently similar to foreign branch income regardless of whether or not
the investor receives a dividend. Subpart F of the U.S. Internal Revenue Code lists the income that
will be treated in this fashion.
Subpart F Income
Subpart F income is income that is easily movable to a low-tax jurisdiction. There are four types
of Subpart F income:
1. Income derived from insurance of U.S. risks.
2. Income from countries engaged in international boycotts.
3. Certain illegal payments.
4. Foreign base company income.
Foreign base company income is the most important category of Subpart F income and
includes the following:
1.Passive income such as interest, dividends, royalties, rents, and capital gains from sales of assets.
An example would be dividends received by a CFC from holding shares of stock in affiliated
companies.
2. Sales income, where the CFC makes sales outside of its country of incorporation. For example,
the U.S. parent manufactures a product that it sells to its CFC in Hong Kong, which in turn sells
the product to customers in Japan. Sales to customers outside of Hong Kong generate Subpart F
income.
3. Service income, where the CFC performs services out of its country of incorporation.

15. 4. Air and sea transportation income.
5. Oil and gas products income.
Determination of the Amount of CFC Income Currently Taxable
The amount of CFC income currently taxable in the United States depends on the percentage of
CFC income generated from Subpart F activities. Assuming that none of a CFC’s income is
repatriated as a dividend, the following hold true:
1. If Subpart F income is less than 5 percent of the CFC’s total income, then none of the CFC’s
income will be taxed currently.
2. If Subpart F income is between 5 percent and 70 percent of the CFC’s total income, then that
percentage of the CFC’s income which is Subpart F income will be taxed currently.
3. If Subpart F income is greater than 70 percent of the CFC’s total income, then 100 percent of
the CFC’s income will be taxed currently.
Safe Harbor Rule
If the foreign tax rate is greater than 90 percent of the U.S. corporate income tax rate, then none
of the CFC’s income is considered to be Subpart F income. With the current U.S. tax rate of 35
percent, U.S. MNCs need not be concerned with the CFC rules for those foreign operations located
in countries with a tax rate of 31.5 percent or higher. These countries are not considered to be tax
havens for CFC purposes.
SUMMARY OF U.S. TAX TREATMENT OF FOREIGN SOURCE INCOME
Determining the appropriate U.S. tax treatment of foreign source income can be quite complicated.
Factors to consider include the following:

16. 1. Legal form of the foreign operation (branch or subsidiary).
2. Percentage level of ownership (CFC or not).
3. Foreign tax rate (tax haven or not).
4. Nature of the foreign source income (Subpart F or not) (appropriate FTC basket).