Why it is critical to reexamine global tax strategies.

Why it is critical to reexamine global tax strategies There have been a number of changes in recent years in how various countries administer tax legislation--changes which will have a significant impact on the financial position of multinationals. These new developments should be a cause for concern as organizations operate in the global marketplace and coordinate their tax strategy with overall corporate objectives.

Gone are the days when a tax paid in one country was simply a credit in another. Today, the emphasis is balanced between the overall effective tax rate and the tax rate paid. In order to entice new business, countries will often allow a tax deferral period or a complete holiday from tax. It is increasingly necessary to evaluate the money paid at a lower effective tax rate against the time value of the money not paid due to a tax deferral or holiday. The strategy of paying taxes in a country and receiving credits for them in another is not as viable as improving cash flow through tax deferral.

Average tax rates worldwide often range between 20 percent and 60 percent of a company's income. The impact of such rates on the cash flow and earnings per share is obvious. Yet, without effective tax planning, income may easily be taxed two or more times as it is shifted among various entities within the organization. Taxes paid in one country do not guarantee a corresponding credit in another country. If the country in which the tax is paid has a higher tax rate than the country giving the credit, the country giving the credit often will allow credit only to the extent that its lower rate would have imposed tax. Even if the credits are given for the full amount, excess foreign tax credits often can't be utilized.

Therefore, to the extent that a competitor has a more efficient strategic plan for global taxes, its competitive edge will certainly be enhanced.

For example, U.S. multinational corporations are finding their tax world far more complex under the Tax Reform Act of 1986. Many also will find their U.S. tax bills higher. TRA 86 makes a number of far-reaching changes, the most important of which are:

* The creation of new, separate foreign tax credit baskets for various types of income, including passive income. This reduces the relief given for global double taxation.

* Revisions to the rules for allocating expenses to foreign sources, effectively denying a U.S. tax deduction for some expenses.

* The expansion of anti-abuse provisions to include banking and certain shipping income.

* The creation of a new "super" royalty concept to reduce deferral. This places the tax consequences of intercompany technology transfers in the hands of local tax authorities.

* And a great expansion of the compliance burden for foreign operations, significantly increasing the administrative burden in coping with the new tax changes.

These changes express Congressional concern that under prior law it was too easy for taxpayers to generate low-taxed, foreign-source income to soak up excess foreign tax credits, thereby reducing their U.S. tax liability. Thus, while the 1986 Act retains the overall limitation that allows taxpayers to use excess credits by averaging high-and low-taxed business income, it severely restricts the ability to use low-taxed, passive foreign income to absorb excess credits. Furthermore, the changes reduce foreign taxable income and available credits while increasing U.S. taxable income. Taken as a whole, the changes exacerbate the excess-credit problems all multinationals face as a result of the overall reduction in U.S. tax rates.

The Tax Reform Act caused sweeping changes in the United States and also triggered foreign tax reform worldwide. Globally, the trend has been toward decreased rates. For example, in December of 1988, Japan passed legislation that will lower its general corporate income tax rate from 42 percent to 37.5 percent. Austria has dropped its rates from 55 percent to 30 percent, while the Netherlands has lowered its rates from 42 percent to a blended rate of 40 percent and 35 percent. Canada has dropped its general corporate rate from 36 percent to 28 percent. And Germany is reducing that country's rate to 50 percent. Thus, when determining your multinational's strategic plan, you can implement global tax planning to use the decreasing tax rates of various countries to their fullest financial advantage.

A global tax review

To incorporate global tax planning into your overall strategic plan, you must first determine the goals of the global tax plan. A global tax review can be an efficient way to establish these goals. This type of review should evaluate your current positioning in the world market, in light of changing tax legislation and policies, and help in constructing your tax planning objectives. These objectives, when met, will allow you to achieve your overall strategic plan without being caught in a snare of tax-related red tape.

One objective of a global tax plan is to structure and position the various entities of a multinational so that you achieve the optimum flow of funds and cross-border transactions are facilitated. Ideally, the entities should be structured so that the transfer of funds will incur minimum or no income or withholding tax liability at each level of the transfer. This will be partially a function of the countries in which the entities are located. Entities should be positioned in countries where the political, legal, and economic hindrances of cross-border transactions are minimal. The often-used Dutch holding company is one example. There are also ways to restructure with low transaction costs.

A global tax plan should consider the legal position of multinational entities within a country. Often the consolidation or merger of separate legal entities in a particular country can optimize their legal effect. For example, if a company with a net operating loss is combined with a profitable company for legal purposes, the loss can be utilized without affecting the management structure and reporting of either company. Thus, the maximum legal benefit is obtained. Optimizing the legal effect of a multinational's entities--for instance, France, Germany, and the U.K. effectively allowing tax consolidations--should be a primary objective of global tax planning.

As the global economic market changes, new opportunities arise within different countries. Nations develop tax incentive or deferral plans to attract new business, or they may even become tax havens, charging little or no income tax. An ongoing objective of a global tax plan it to be alert to the opportunities that exist by creating new entities within such tax-haven jurisdictions. These might include Irish manufacturing companies, Belgian coordination centers, Hong Kong offshore companies, or Swiss management companies. Therefore, as with any part of the overall strategic plan, global tax planning must be consistently monitored and then updated when necessary.

Improved cash flow is an overall strategic goal of most multinationals. Global tax planning can assist in realizing that goal by making one of its objectives the reduction or deferral of local foreign country taxes. The active evaluation of local taxes on an entity-by-entity, country-by-country basis, with the goal of minimizing or deferring taxes, will help you pay a lower tax rate and at the same time improve your cash flow. It's interesting to note, for instance, that, in Japan, purchased goodswill is immediately deductible. In the U.K., interest income is taxed on a cash basis. In France, foreign dividends are generally not taxed. And, in Germany, investments in lower-tier German subsidiaries can be written down to fair value.

Available techniques

After you determine the objectives of a global tax plan, you must pay attention to achieving the objectives. The intricacies and ever-changing nature of tax legislation demand the development of specific techniques to do so.

When identifying planning opportunities, consider any techniques previously available in the U.S. thay may still be available in foreign jurisdictions. For example, foreign-based company activities such as captive factoring, insurance, sales or services may be useful to shift income from high-tax jurisdictions to low-tax jurisdictions. In addition, techniques such as the installment method, completed contracts, and leveraged leasing may be available in certain foreign jurisdictions to help reduce or defer foreign taxes.

The entire area of financing is fertile territory for optimium tax planning. Some intercompany instruments may be cosidered debt in one country and equity in the reciprocal country (German silent partnerships, U.K. perpetual loans, etc.). Because of the recent U.S. restrictions on deducting interest, placing debt at the local affiliates is generally desirable but may incur sizable costs.

Additionally, cross-border leasing can be used as another form of financing with positive tax results. For example, a French legal lessor of equipment to an affiliated U.K. legal lessee, where the lease is really a financing arrangement, allows both the French and U.K. companies to claim depreciation.

Also, the specific legal entity chosen in which to do business locally can have a significant impact on global tax planning. Doing business as a branch locally will generally allow branch losses to be deducted in the home country; however, operating as a branch may have many local disadvantages. Yet there are certain entities that are viewed locally as separate legal entities, while in a home country they could be viewed as a branch. For example, a U.S. company owning a French S.N.C. (societes en nom Collectif) could deduct in the U.S., as foreign source, the losses of the French S.N.C.

Similarly, foreign joint ventures present interesting opportunities. For example, in the U.S. there are strict foreign tax credit limits on those U.S. companies owning 50 percent or less of the stock of a foreign corporation. Therefore, if a U.S. company owns between 10 percent and 50 percent of the stock of a foreign company with active income, the U.S. company should consider obtaining more than 50 percent of the foreign firm in order to avoid the company-by-company limitation and to take advantage of the more favorable U.S. look-through rules. The 50-percent value test, added to the control test, will allow favorable status to be achieved without changing voting control. For example, buying preferred stock in the foreign joint venture could result in more than 50-percent ownership in the foreign joint venture company (for purposes of Subpart F). Also, the company could purchase a part of the other principle shareholder of the foreign joint venture, thereby increasing ownership through indirect means.

Repatriation of funds via a royalty becomes more advantageous where the foreign jurisdiction taxes at a rate in excess of the home country rate. From the U.S. perspective, the royalty received from an active affiliate willll be a low-taxed, foreign-source income in the active basket and can be sheltered with the excess credits generated by the other foreign income. In addition, to the extent that a deduction is allowed in the foreign country, a tax rate benefit is achieved, further reducing the company's worldwide tax burden.

In countries such as Ireland, Puerto Rico, and Mexico, you should consider restructuring operations to take advantage of local tax incentives and tax holiday provisions. For example, some companies may be able to set up headquarter-type operations through the use of, say, a Belgian coordination center (or similar entities in the Netherlands, France, and Singapore) to take advantage of local tax incentives as well as to shift income out of high-tax countries.

In addition to strategic foreign tax credit planning, local country planning is also crucial in improving a company's overall global tax position. You must look at your corporate structure on a worldwide basis to ensure that the proper alignment is present to facilitate cross-border tax planning.

Finally, don't overlook tax techniques and strategies that competitors are employing for a competitive edge. To the extent that information is available, it is usually helpful to determine what a competitor is doing tax-wise, both on a global basis as well as in each locale.

Intercompany transactions 

In today's business world, competitive pressures are no longer confined to local or even national markets. It's commonplace for a firm to provide financial or management assistance to a foreign subsidiary. Manufacturing may be performed in one location with the product being resold to a marketing affiliate for final distribution in another country. The movement of intangible assets, such as patents, trademarks, and technical know-how, in accordance with licensing or royalty agreements is a common characteristic of a business that is organized on an international basis.

This pattern of geographic specialization is motivated by a never-ending search to reduce costs, maintain and improve profits, and stay competitive. Indeed, many businesses have no choice; to be competitive they must adopt an international production and marketing strategy. In Europe, in particular, this is stress will become greater as the harmonization of 1992 approaches. But an international business structure also raises vital taxation issues that require acute awareness, careful planning and an effective response when questions are raised by tax authorities.

Parent corporations commonly assist affiliates with management and administrative support. Such services must be performed with the intent to benefit the related entity, in which case management fees remitted to the parent represent taxable income to the parent and are deductible by the affiliate. This arrangement is beneficial when the parent company is located in a low-tax jurisdiction and where the affiliate is subject to a much higher tax rate. Some treaties may provide for zero taxation of income not covered by a specific provision. Management fees and/or investment income may constitute other income and, therefore, may be exempt from tax.

For tax purposes, virtually all countries require that the transfer prices at which goods and services are exchanged between related or affiliated entities be set on an "arms-length" basis. This means that the price at which a transaction between related or affiliated divisions or companies is valued must be similar to the price that would be charged if the parties were unrelated and dealing at arm's length.

A corporation that fail to recognize the likelihood of a transfer-pricing adjustment risks incurring higher taxes, double taxes, reduced earnings, a depressed stock price, and ultimately discontented shareholders. It also may have to make a change in its financial statements to reflect the impact of the proposed adjustment. To avoid these adverse consequences, businesses must be prepared to offer a defense against proposed transfer-pricing adjustments with a strategy of preventive pricing.

Given recent developments in the U .S., it is likely that intercompany pricing will be the major area of focus of international tax authorities in the future. It is imperative that multinationals get a good handle on their intercompany pricing economics. The various functions performed by each affiliate in the income-generation process must be identified and the value added by each function determined and well documented. A company that fails to do so runs the risk of significant double taxation.

The goal: corporate wealth

In summary, in order to achieve the goals and objectives that have been defined, companies must implement a variety of techniques. After choosing the techniques, they must determine who should be involved in implementing the global tax plan. Top management is the first choice. This is true of any part of the overall strategic plan. Naturally, both U.S. and foreign tax personnel also need to be intrinsically involved. But without top-level support, their efforts are of only minimal value. Last, operations people on a worldwide basis have to be involved. These individuals are needed since most planning ideas can directly affect the overall operation of the company. Therefore, their input is required in order to analyze the nontax impact of certain tax planning ideas. Then, top management must help weigh all the advantages and disadvantages, whether or not tax related, of implementing any portion of the global tax planning strategy. Companies shouldn't fall into the trap of letting management reporting procedures, local incentive standards, or local management egos get in the way of implementing key global strategic tax plans.

As you can see, the purpose of using global tax planning is not just to reduce tax worldwide but actually to increase a corporation's worth, through cash flow and/or higher earnings per share. Therefore, the goals of global tax planning must fit into harmony with a company's overall strategic plan. In order to establish a global tax plan, you must understand the company and its overall objectives, including such major issues as a proposed expansion, any planned new location of facilities, and the development of new products.

Once the global tax plan is understood and appears to fit into the overall strategic plan, a final important issue needs to be determined: the timetable. Without a timetable, there is no measure of the implementation of the plan. With this timetable, a clear objective has been established, and those involved will be reviewed against this objective. Once implemented, the timetable doesn't stop. The global tax plan must be continually reviewed and reevaluated.

A global tax plan may take a lot of time and effort to establish and maintain. But, like any part of operations, the time and effort will pay off through increased corporate wealth. The benefits of this type of planning are unlimited.

This article was contributed by FEI's Committee on International Business.