ACCA P4 Advanced Financial Management - 2010 - Study text

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Chapter 17: Financial management and multinationals

Tax rates

The rate of taxation on profits will vary between the two countries and two

companies concerned. As a general principle, the aim of a group should be to set a

transfer price that shares the profits in a way that reduces the profits of the company

in the higher-tax country.

For example, suppose that a parent company in country A sells goods to its 100%-

owned subsidiary in country B, and the rate of tax is 20% in country A and 30% in

country B. The transfer price should be set as high as the tax rules permit, because

this will increase profits of the parent company in lower-tax country A and reduce

the profits of the subsidiary in higher-tax country B.

Double taxation agreement

There should usually be a double taxation agreement between the two countries.

From the point of view of the parent company, this means that:

 If the rate of tax on profits is higher in the country of the foreign subsidiary than

in the parent company’s country, the subsidiary pays tax in its own country on

its profits at the rate applicable in that country. No further tax is payable in the

parent company’s country on the profits of the foreign subsidiary.

 If the rate of tax on profits is lower in the country of the foreign subsidiary than

in the parent company’s country, the subsidiary pays tax in its own country on

its profits at the rate applicable in that country. However, tax is also payable by

the parent company in its own country. The tax payable is the difference

between tax on profits at the rate in the parent company and the tax payable by

the subsidiary in its own country.

Withholding tax

Withholding tax is additional tax that is ‘withheld’ when a company pays interest or

dividends to a foreign investor. It affects international groups where foreign

subsidiaries are located in a country where withholding tax is charged. Payments of

interest or dividends by a subsidiary to the parent company will be subject to the

withholding tax.

Tax rules on transfer prices

The tax rules in a country are likely to make it difficult for an international group to

charge inter-company transfer prices that are significantly different from market

prices (where these exist). This is because the tax authorities recognise that transfer

prices might be set artificially so as to minimise the total tax burden for the group.

These various tax aspects of transfer pricing are illustrated by the following

example.

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Example

A UK company has recently acquired a foreign subsidiary in another country,

Outland. A part of the operating arrangements of the new group is that the parent

company will export a component to the subsidiary, and the subsidiary will use this

component to make a product that it will sell in Outland. The management of the

parent company have to decide what the transfer price for the component should

be.

The following information is available:

UK (annual) Outland (annual)

Components transferred to

Outland

100,000 units Units of product sold 100,000 units

Sales price per unit $150

Variable cost per unit £15 Local variable cost per unit $40

Fixed costs £900,000 Local fixed costs $600,000

Tax rate 30% Tax rate 25%

The exchange rate is £1 = $4.

Withholding tax of 10% is charged on all remittances of interest and dividends from

Outland. The UK parent company intends to remit all available profits from

Outland to the UK.

There is a double taxation agreement between the UK and Outland. Tax on income

and distributions in one country may be credited against a tax liability on the same

income in the other country.

Required

Calculate the group profits if the transfer price for the component is set at

(a) its market price, which is £26 per unit

(b) total UK cost per unit plus 25%.

Answer

Tax on profits in Outland will be 25%, but there will be an additional withholding

tax of 10% since all available profits will be remitted to the UK. The total tax payable

on income in Outland is therefore 35% which is higher than the rate of UK tax. This

means that profits earned in Outland will not be taxed at all in the UK.

(a) Transfer price = market price

Parent company, UK

£ £

Component sales (£26 per unit) 2,600,000

Variable costs (£15 per unit) 1,500,000

Fixed costs 900,000

2,400,000

Profit before tax 200,000

Tax at 30% (60,000)

Profit after tax 140,000

Chapter 17: Financial management and multinationals

The transfer price in Outland dollars is £26 × $4 = $104.

Subsidiary company, Outland

$ $

Product sales ($150 per unit) 15,000,000

Transfer costs ($104 per unit) 10,400,000

Local variable costs ($40 per unit) 1,500,000

Local fixed costs 600,000

12,500,000

Profit before tax 2,500,000

Tax at 25% (625,000)

Profit after tax 1,875,000

Withholding tax at 10% (187,500)

Profit in the UK after tax 1,687,500 = £421,875

The total group profit will be £140,000 + £421,875= £561,875.

(b) Transfer price = cost plus 25%

Total UK costs are £2,400,000 or £24 per unit. Cost plus 25% = £30 per unit.

The transfer price will therefore be £30, which is $120 per unit.

Parent company, UK

Component sales (£30 per unit) 3,000,000

Total costs (as above) 2,400,000

Profit before tax 600,000

Tax at 30% (180,000)

Profit after tax 420,000

Subsidiary company, Outland

$ $

Product sales ($150 per unit) 15,000,000

Transfer costs ($120 per unit) 12,000,000

Local variable costs ($40 per unit) 1,500,000

Local fixed costs 600,000

14,100,000

Profit before tax 900,000

Tax at 25% (225,000)

Profit after tax 675,000

Withholding tax at 10% (67,500)

Profit in the UK after tax 607,500 = £151,875

The total group profit will be £420,000 + £151,875 = £571,875.

The higher transfer price will provide a bigger after-tax profit for the group.

However, the tax authorities in Outland might not agree to accept a transfer

price of $20, because this is $4 per unit above the market price for the

component.

2.3 Multinationals and tax planning

Multinationals are subject to tax on their profits in all the countries in which they

operate. They are also subject to tax on their world-wide profits in their country of

registration. As explained earlier, the tax burden is reduced by the existence of

double taxation agreements between countries, and a multinational is able to set off

tax paid in foreign countries against tax payable in the country of registration.

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For example, a UK multinational may be liable to tax in Country X on the profits of

a subsidiary in Country X. Suppose that the amount of this tax liability is the

equivalent of £500,000. The UK parent company will also be liable to tax in the UK

for the profits (or dividends) of the foreign subsidiary. If a double taxation

agreement exists between the UK and Country X, the following tax positions might

arise.

 If the UK tax liability for the foreign subsidiary is more than £500,000, tax

payable in the UK will be reduced by the tax payable in Country X (£500,000).

 If the UK tax liability for the foreign subsidiary is less than £500,000, no tax is

payable in the UK.

Tax planning to reduce a tax liability

A multinational may be able to reduce its world-wide tax liability through tax

planning. One measure might be to establish a subsidiary company in a tax haven,

and by channelling its profits and capital gains in other countries through the tax

haven, its total tax liability might be reduced.

An example may help to illustrate this point.

Example

A UK multinational company has three wholly-owned foreign subsidiaries, in

Country A, Country B and Country C. The profits of each subsidiary for the year are

the equivalent of £100,000. The rate of corporate tax in the UK is 30%.

The tax rates in the other countries are set out below.

Country

Tax on

profits

Withholding tax on

dividends

% of after-tax profit

remitted to the UK as

dividends

Country A 20% 5%

Country B 25% -

Country C 40% 10%

Double taxation agreements exist between the UK and each of the three countries.

Required

Calculate the world-wide tax liability of the UK multinational in each of the three

following circumstances:

(a) The UK government charges companies tax on the dividends remitted from

foreign subsidiaries. The amount of the dividend is grossed up at the local tax

rate, before deduction of any withholding tax, and UK tax is calculated on this

grossed-up dividend.

(b) The UK government charges multinationals tax on the gross income of their

foreign subsidiaries. A tax credit is available for all corporate taxes paid in

foreign countries, including withholding tax.

from the foreign subsidiaries would be transferred to the UK via this tax haven

Chapter 17: Financial management and multinationals

company. The UK government would then treat all the foreign income as

coming through a single source, the tax haven company in Country D.

Calculate the total tax payable on the foreign profits of the multinational if the

tax rules are:

(i) the same as in (a)

(ii) the same as in (b).

Answer

(a)

Country A Country B Country C

£000 £000 £000

Taxable income

100.0

100.0 100.0

Local tax on profits (20%)

20.0

(25%)

25.0 (40%) 40.0

80.0

75.0 60.0

Dividend payment

before withholding tax

(90%)

72.0

(90%)

67.5 (80%) 48.0

Withholding tax (5%)

3.6

(10%) 4.8

Dividends to UK before

deducting withholding

tax

72.0

67.5 48.0

Gross up for local tax (× 100/80)

90.0

(× 100/75)

90.0 (× 100/60) 80.0

UK tax liability at 30%

27.0

27.0 24.0

Foreign tax credit (see

note below)

(20 + 3.6)

23.6

25.0 24.0

UK tax payable

3.4

2.0 0.0

Note: The foreign tax credit is the lower amount of tax payable in the foreign

country and tax payable in the UK.

Summary £000

Tax payable in other countries (20 + 25 + 40 + 3.6 + 4.8) 93.4

Tax payable in the UK (3.4 + 2.0)

5.4

Worldwide tax liability 98.8

(b)

Country A Country B Country C

£000 £000 £000

Taxable income

100.0

100.0 100.0

Local tax on profits (20%)

20.0

(25%)

25.0 (40%) 40.0

80.0

75.0 60.0

Dividend payment before withholding

tax

(90%)

72.0

(90%)

67.5 (80%) 48.0

Withholding tax (5%)

3.6

(10%) 4.8

Income for UK tax purposes

100.0

100.0 100.0

UK tax liability at 30%

30.0

30.0 30.0

Foreign tax credit (see note above)

23.6

25.0 30.0

UK tax payable

6.4

5.0 0.0

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Summary £000

Tax payable in other countries (20 + 25 + 40 + 3.6 + 4.8) 93.4

Tax payable in the UK (6.4 + 5.0)

11.4

Worldwide tax liability 104.8

Under these tax rules, more tax is payable in the UK than with the tax system

in (a).

(c)

Tax system

in (a)

Tax system

in (b)

£000 £000

Tax payable in other countries

93.4

UK tax liability (90 + 90

+ 80)

260.0

300.0

UK tax at 30%

78.0

90.0

Foreign tax credit

78.0

90.0

Tax payable in the UK

0.0

The worldwide tax payable is just £93,400 because no tax is now payable in

the UK (because a tax credit of up to £93,400 would be available). Setting up

the tax haven therefore reduces the word-wide tax burden for the

multinational.

Chapter 17: Financial management and multinationals

Free trade and protectionism

 Protectionism

 Free trade

 The arguments for free trade and potectionism

 Common markets

 Restrictions on movements of capital or currency

 World Trade Organisation (WTO)

3 Free trade and protectionism

You need to be aware of the arguments for and against free trade, and for and

against protectionism.

3.1 Protectionism

Protectionism involves measures by a national government to protect its domestic

industries and companies against competition from imports by foreign suppliers.

Protectionism takes several forms.

 Taxes on imports of particular types of goods. These are import tariffs, which

are charged on goods entering the country.

 Import quotas. These are limits on the quantities of particular items that can be

imported.

 Import ban. There might be a ban on the import of certain items.

 Procedural regulations that make it time-consuming and expensive to import

goods (for example, documentation requirements, slow procedures by the

customs authorities).

 Imposing regulations relating to the required minimum standard of products,

which imported goods may not meet; for example a country may impose that

require particular products (such as cars) to meet minimum environmental

regulations.

 Regulations requiring a proportion of any new business to be owned by ‘local’

companies or individuals.

 Providing government subsidies to national companies, so that they can

compete more successfully against foreign companies. For example, the

European Union is criticised in discussions on world trade for the large

agricultural subsidies paid to its farmers.

 Protectionist measures may also take the form of government restrictions or

legal restrictions on the purchase of domestic companies by foreign investors or

foreign companies.

Protectionist measures are used by governments to preserve jobs and businesses in

their own country. They exist not only in developing and under-developed

countries, but also in countries with advanced economies.

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3.2 Free trade

Free trade is the conduct of international trade without protectionist measures. Free

trade involves the absence of import tariffs (or the taxation of imported goods at the

same rate as the tax on domestically-produced goods), and the absence of import

quotas and government subsidies.

3.3 The arguments for free trade and protectionism

The governments of many countries have accepted the principle that free trade will

increase the total volume of international trade. Total output in the world

economies will grow, there will be more employment. Economic growth creates

additional wealth. The supporters of free trade argue that this additional wealth will

benefit all the countries involved and will be shared between them.

However, although there is agreement on the principle that free trade leads to

growth in the world economy, it might be argued that it increases the wealth of

some countries but reduces the wealth of others. For example, free trade might help

the economies of the advanced industrialised nations to expand, but might prevent

the economies of under-developed countries from growing. It might therefore be

argued that protectionist measures are necessary to give domestic industries an

opportunity to develop, and to protect jobs in those industries.

There are also difficulties raised by the fact that protectionist measures exist and are

used extensively by governments. Some countries refuse to abandon their measures

for protection as long as another country still has different measures in place

relating to different industries and products. For example, one country night refuse

to remove tariffs on imports of agricultural produce when another country charges

tariffs on imports of electronic goods.

There are also some difficulties relating to intellectual property, such as patents,

trade marks and copyright. Although there are international agreements for the

protection of intellectual property, not all countries have subscribed to them and

intellectual property laws are not applied worldwide. This creates disputes between

countries that have such laws and those that do not.

The World Trade Organisation seeks to achieve free trade internationally, but needs

to win the agreement of all the countries affected. Progress towards the abolition of

protectionism has therefore been slow (and continues to be slow).

3.4 Common markets

Some countries have joined together to create common markets in which there is

free trade between the member countries. The most notable example is probably the

European Community, particularly the eurozone of countries sharing the euro as

their common currency.

Free trade and either a common currency or exchange rate stability create an

environment in which international trade can grow.

Chapter 17: Financial management and multinationals

3.5 Restrictions on movements of capital or currency

Some developing countries seek to restrict the movement of capital or foreign

currency out of the country, by imposing foreign exchange restrictions or

restrictions on the movement of capital.

You might be given an examination question involving the appraisal of a proposed

capital investment in a foreign country where the government applies restrictions

on the payment of dividends to foreign shareholders. Companies investing in the

country (by setting up a local subsidiary) are therefore unable or unwilling to

‘repatriate’ the profits from their foreign investment, because:

 there is a ban on payments of dividends to foreign investors, so that companies

they cannot pay themselves dividends on the profits of their foreign subsidiary ,

 (more commonly) there is a withholding tax on the payment of dividends and

interest to foreign investors, so that companies have to pay an additional tax if

they want to repatriate profits of their foreign subsidiary.

3.6 World Trade Organisation (WTO)

The World Trade Organisation is an organisation to which countries become

members on a voluntary basis. Most countries of the world are members of the

WTO.

The aim of the WTO is to encourage countries to:

 adopt more free trade measures

 remove protectionist barriers against imports of goods or services from other

countries

 ban the practice of ‘dumping’ surplus goods at a low price on the markets of

other countries. (Dumping can have a serious adverse effect on the domestic

industry of the countries where the goods are ‘dumped’.)

The WTO promotes the view that reducing barriers to world trade (protectionist

measures) will promote economic growth and prosperity.

There are three key agreements that have been negotiated and signed by most of the

world’s governments:

 The General Agreement on Trade and Tariffs (GATT). This is an agreement

relating to trade in goods.

 A General Agreement on Trade in Services

 The Agreement on Trade-Related Aspects of Intellectual Property.

These agreements contribute towards free trade and the removal of protectionist

barriers, but they are not ‘perfect’ and many protectionist measures still exist. Some

of these measures can lead to serious disputes between governments, which

sometimes escalate. One country’s government might demand the removal of

protectionist measures against its exports by another country, and make threats of

protectionist counter-measures in retaliation.

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It is generally accepted that there is still a long way to go in achieving the objective of

free trade. Member countries meet regularly and try to come to agreements on trade.

The WTO encourages direct discussions between particular countries or blocs of

countries, such as the US and the European Union, and offers an arbitration service

for the settlement of trade disputes.

All member countries also meet regularly to try to agree a world-wide series of new

measures to enhance free trade and remove trade barriers. The so-called Uruguay

Round of discussions began in 1986 and agreement was eventually reached on some

new measures in 1994.Starting in 2001, the WTO tried to obtain agreement to a

variety of new measures. The discussions between governments have been called the

‘Doha Development Agenda’ or the ‘Doha round’ of talks. So far, the talks have failed

to make any significant progress, and the discussions were formally suspended in

July 2006 without any agreement having been reached.

ACCA P4 Advanced Financial Management - 2010 - Study text - Emile Woolf Publishing

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