as india continues to experience increased dosage of capital infusion

8/7/2019 As India continues to experience increased dosage of capital infusion

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TAXATION ISSUES FOR MNCs

As India continues to experience increased dosage of capital infusion, enhanced

international trade and web of trade and tax conventions, out tax competitiveness will be

watched by the world leaders.

Multinational corporations(MNC)

A company or corporation that has manufacturing or trading interests in two or more countries.

It may take the form of a holding company based in one country with subsidiary companies in

other countries.A large scale business enterprise having their branches or collaborations with

whole or majority ownership of interests in a number of countries. Also called a multinational

enterprise (MNE), a company that has facilities, such as those for production and marketing, in

various countries other than its country of origin. A large scale business enterprise having their

branches or collaborations with whole or majority ownership of interests in a number of

countries.

An MNC is a corporation that has operations in more than one country by way of FDI.

The ILO has defined an MNC as a corporation that has its management headquarters in one

country, known as the home country, and operates in several other countries, known as host

countries and these subsidiaries are tightly

or loosely controlled by the headquarter.

The first modern is generally thought to be the East India Company.

A company that has only exporting relationships with other countries is not a true MNC.

Sourcing & producing goods/services from locations around the world to take advantage of

national differences in cost & quality factors.

Individual MNCs disperse different parts of their operations to narrow set of locations around the

world because of:

National advantages in factors of production key to the where to produce? decision


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Global web of suppliers

Advantages of MNCs

Economic Growth and development

Employment generation

Skills, production techniques and improvements in the quality of human capital

Availability of quality goods and services

Tax Revenues

Improvements in Infrastructure

Better management practices

Disadvantages of MNCs

Employment might not be as extensive as hoped - many jobs might go to skilled workers from

other countries rather than to domestic workers.

Some MNCs may be 'footloose'; they might locate in a country to gain the tax or grant

advantages but then move away when these run out. As a result there might not be a long term

benefit

Investment into capital intensive production facilities might not bring as many jobs to an area

as hoped.

The size and power of multinationals can be used to exploit weak or corrupt governments to get

better deals

Pollution and environmental damage.

Some companies might be producing goods that are not beneficial e.g. tobacco products and

alcohol

Profits might go back to the headquarters of the MNC rather than the host country - the

benefits, therefore, might not be as great.


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TYPES OF MNCS

1-THEETHNOCENTRIC ORGANIZATION

Key Fetures

Assumes uniformity in markets and hence parent country perspective dominates.

Experience curve allows learning through repetition and thus facilitates economies of scale

through standardization of product.

It entails effectively transferring knowledge of one market to another.

Characterized by either exporting relationship or centralized headquarter subsidiary

relationship headquarter-relationship.

Tight controls exercised by headquarter. Key decisions centrally made centrally.

2-THE POLYCENTRIC ORGANIZATION

Key features

Assumes that marketing or production

considerations favor geographic diversification and unique propositions. Individual differences and nuances mandate a unique strategy for each market.

It is effective when MNE cannot transfer knowledge of markets.

Consists of a set of freestanding divisions with loose headquarter loose, simple controls merely

for coordinating strategic intent.

Linked to each other and the parent on the basis of a shared portfolio and corporate identity.

3-THEGEOCENTRIC ORGANIZATION

Key features

Assumes think global act local is the best strategy.

Balance between multiproduct capabilities and scale economies.

Worldwide integration of businesses through extensive networking, resource transfers and

information sharing.


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Complex process of coordination in an environment of shared decision making making.

Typically a matrix organization, characterized by interchange of people large flows and and

resources among units.

MODES OF OPERATION IN INDIA

A multinational corporation is a large firm with its head office in one country and

several business units operating overseas. The head office implies the prime operation

base of the company. Thereafter to expand its operations, the multinational looks for

markets in other countries.

To gain competitive advantage as also to capture sizable market share in the foreign

markets the multinational may opt for various strategies. It could go in for forward

integration or backward integration depending upon its core competencies and

competitiveness in the respective sector. One other option that is available as well as

beneficial is to acquire similar firms in other countries i.e., acquire similar units.

Due to mergers, multinationals can save vital time on setting up their own plant and

facilities and that too right from scratch. In other words, it gets access to a readymade

plant or facility in the foreign market. Some types of mergers that a multinational

can opt for are as under:

Vertical Corporations - These are corporations that have purchased the component

businesses that make their product. For example, ifApple Computers bought Intel

(the chip manufacturer), a plastics company (for the cases) a shipping company, a

CD Rom maker, etc, they would be limiting their costs by purchasing the companies

that they used to purchase component products from.

Horizontal Corporations - These are corporations that have purchased competing

companies in an attempt to eliminate the competition and gain market share. It

would be like IBM purchasing Compaq, Dell and Gateway. The FTC (Federal Trade

Commission) watches this very carefully to ensure that anti trust laws are not violated.

Some horizontal mergers may be illegal and are halted.

Conglomerates - This is when one company buys other companies that are unrelated

to their core business in an attempt to diversify. Corporations may become

conglomerates after becoming very large through mergers and acquisitions of a variety


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of businesses. Diversification is one of the main reasons for conglomerate mergers.

By having component businesses each making unrelated products, the overall sales

and profits will be protected. For example, isolated economic events, such as bad

weather or the sudden change of consumer tastes, may affect some product lines at

some point, but not all at one time. One classic conglomerate is ITC which at one

point owned international long distance phone service (their original core business),

the Sheraton Hotel chain, a large insurance company, a defence contractor and others.

INDIAN MULTINATIONAL

When some major Indian business houses established Greenfield manufacturing joint

ventures abroad, but most of them, with the exception of the AV Birla group, did not

do very well. The Birla groups own ventures abroad were as much the result of

business opportunity there, as of the frustration with the denial of industrial licenses

in India. The situation has, of course, changed dramatically over the last decade.

India Inc. is flying high. Not only over the Indian sky. Many Indian firms have slowly

and surely embarked on the global path and lead to the emergence of Indian

multinational companies.

With each passing day Indian businesses are acquiring companies abroad becoming World-

popular suppliers and are recruiting staff cutting across nationalities. While Asian Paints is

painting the World red, Tata is rolling out Indicas from Birmingham and Sundram Fasteners

nails home the fact that the Indian company is an entity to be reckoned with. The economic

reforms that began in the early 1990s brought many large multinational companies to India. A

major challenge for these corporations was to manage the interface of global corporate culture

and Indias powerful, traditional and widely varying cultural practices.

Multinationalism in India - Outsourcing

The economic reforms that began in the early 1990s brought many large multinational

companies to India. A major challenge for these corporations was to manage the interface of

global corporate culture and Indias powerful, traditional and widely varying cultural practices.

The story of outsourcing is about extremely fast-paced change. It has been affecting the lives of

many. Interestingly, it had a quiet beginning in the early 1990s when pioneers such as GE,

Citibank, Amex and British Airways set up captive units in India. Now this trend has burgeoned


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into a huge industry with third party Information Technology Enabled Services (ITES)/Business

Process Outsourcing (BPO) companies bagging prestigious remote services projects from

leading global organizations. In 2003-04 alone, outsourcing in India grew over 25 per cent, and

India continued its domination over other competing countries such as China, Ireland, Israel and

the Philippines. Based on these factors, projections are flying thick and fast Fortunately, India

appears to be in a position to cater to the demands of the market. Its biggest strength is its vast

supply of over 2 million graduates and 300,000 post graduates that pass out of its colleges each

year. Its vast resource of English-speaking college-educated workforce and low-cost labour gives

it an edge in the offshoring World. It isnt only the cost factor that continues to make India an

attractive outsourcing destination. The quality of manpower combined with an extremely

sophisticated vendor base and improvements in local infrastructure have put it ahead of other

offshore destinations.

A review of Indians in one of the news articles abroad speaks as follows New generation

Indians employed in GE and other MNCs that grew up in posteconomically liberalised India, are

a new breed with a zip in their step. Theyre hungry, theyre energetic. Theyre demanding of

their government. We interviewed so many of these call centre workers. You bring up Pakistan

to them say, Pakistan? Kashmir? Theyll say they got better things to do. Its about the global

supply chain. You see, when India is part of GEs global supply chain, when they are actually

involved in the day-to-day operation of GEs health care, call centers, payroll, they cant take a

day off for war.

Objectives of FDI policy in India through mncs

technology transfer

technology diffusion

limitations on foreign ownership

save foreign exchange

national independence

priority sectors


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employment creation

avoid concentration

diversification

local content

export promotion

advancement of Indians

local R&D

regional development

capacity utilization

Taxation Trends in the European Union

Examining recent taxation trends in the European Union can shed some light on

the future of taxation among DMCs. Although no group of DMCs have committed to

forming an economic grouping that would be as deeply integrated as the EU, many

DMCs have entered into RTAs that have a mandate to reduce trade barriers among

member countries. In terms of taxation, the EU seeks to harmonize taxes among

member countries in order to avoid the race to the bottom among tax

administrations. To realize this goal EU member countries have increasingly come to

rely on multilateral rather than bilateral tax agreements. Multilateral agreements

normally require that signatories adopt compulsory rules or recognize an

international governing body. Most governments are less willing to relinquish

sovereignty over direct taxes than indirect taxes. In Europe, the EU has harmonized

indirect taxes, such as sales tax, more successfully than direct taxes, like corporate

income tax. This should be good news to developing countries because sales tax is

generally easier to administer and collect than income tax. Although the EU has not

yet successfully harmonized direct taxes, discussions about harmonizing corporate

taxes are ongoing. The EU has long experimented with various policy responses to


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the intensifying globalization and technology advancement. The EU experience

suggests that DMCs will have to shift away from bilateral toward multilateral tax

agreements. In preparation for the shift, regional tax policymakers should discuss

the possibility of regional cooperation and harmonization of tax policies.

EMERGING KEY ISSUES FOR TAXES

With globalization and technological advancement, factors of production move across

borders more freely. Goods and services are traded in a greater volume all over the

world. Given the freedom of movement, capital, labor, raw materials, and intermediate

and final goods and services tend to move to and be consumed in lower-tax countries.

As globalization and technological advancement accelerate, many tax jurisdictions

compete among themselves by reducing tax rates or introducing tax incentives to attract

investors and mobile, skilled laborers. European Union (EU) members have long

suffered from harmful intra-EU tax competition. The EU has therefore continually striven

to develop policies and mechanisms that would reduce harmful tax competitionthe so-

called race to the bottom problem. EU tax authorities have been actively designing

and legalizing tax harmonization to curb tax competition.

Multinational corporations (MNCs), which have a special interest in expanding their

operations globally, can penetrate and become important players in developing markets

because local companies have limited capital to compete. However, developing

countries have limited knowledge of MNC mechanisms and operations. Since countries

in the Organization for Economic Co-operation and Development (OECD) are home to

many MNCs and since the OECD is considered the global authority on the perations of

MNCs, tax authorities of developing countries can minimize revenue loss by learning

about OECD guidelines such as those governing transfer pricing. MNCs tend to

manipulate transfer prices among their subsidiaries to minimize their overall tax

liabilities. In response to trade competition from outside the region, many developing

member countries (DMCs) of the Asian Development Bank are seeking to establish,

expand, and deepen regional trade arrangements (RTAs). Joining an RTA generally

reduces DMCs short term tax revenue, since these countries rely heavily on

international trade taxes. To compensate for such losses, tax authorities should


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introduce or improve the collection of buoyant and broad-based taxes such as value

added tax (VAT) and general sales tax. VAT is especially important because it is difficult

to evade while tax bases of other taxes are shrinking due to globalization and

technological advancements. Globalization and technological advancements reduce

both the efficiency and equity of tax systems by complicating tax collection and creating

new ways for avoiding or evading taxes. They also allow taxpayers to raise income

outside of conventional channels without tax authorities knowledge. To raise and

maintain taxpayers morale and to make them aware of their responsibilities, rule-based

tax laws and practices must be honored. Good governance and good tax practices are

all-around improvements that governments can use to bolster their revenue collection in

the face of globalization and technological advancement.

Transfer Pricing

Although developing countries are advised to concentrate primarily on indirect tax

reforms, direct tax in the form of corporate income tax remains one of the most

important revenue sources for DMCs. Furthermore, as MNCs are increasing their

presence in the region, DMCs face the growing risk of losing tax revenue to MNCs that

manipulate transfer pricing. Transfer pricing refers to the setting of prices for

transactions among multinational enterprises that are subsidiaries of a multinational

corporation, where the prices are not subject to market determination. MNCs often

manipulate transfer prices among subsidiaries in different tax jurisdictions to minimize

overall corporate tax liabilities. For example, two trading partners who are subsidiaries

of the same MNC may evade corporate income tax using the following tactic. The

purchasing subsidiary might overstate the price of a product sold by the selling

subsidiary when the selling subsidiary is subject to a high tax rate and the purchasing

subsidiary is subject to a lower tax rate. The OECD has adopted international tax rules

that address the problem of transfer pricing by enabling tax authorities to adjust transfer

prices using the Arms Length Prices (ALP) principle. The ALP principle states that if

conditions made between associated enterprises in their commercial or financial

relations differ from those that would have been made between independent

enterprises, then profits that would have accrued to one of the enterprises may be


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included in the profits of that enterprise and thus be subject to taxation. The ALP

principle is designed to eliminate tax distortions by treating all enterprises as separate

entities regardless of their relationship. Although applicable to most transactions, the

ALP principle has its shortcomings. Since multinational enterprises take advantage of

economies of scale, transactions among their subsidiaries are often genuinely less

costly than transactions between nonrelated entities. Multinational enterprises also

undertake transactions that independent entities would never make. These factors

make it difficult for tax authorities to apply the ALP principle. To make matters worse,

tax authorities normally do not audit such transactions until several years after this

occurrence and it is difficult to get relevant information about market prices of

transactions between independent entities. To cope with these problems, the OECD

recommends pecific guidelines for tax authorities to assess Arms Length prices that

are flexible but based on specific methods that are compatible with the transaction.

Applying these guidelines yields a range of prices that would require a compromise

between taxpayer and tax authorities. For a DMC, this happy medium is naturally an

outcome of adopting and adapting established rules from developed countries before

the DMC perfects its own rules. As of now, DMCs can immediately adopt and

implement these OECD-originated guidelines to reduce revenue loss due to tax

avoidance by MNCs.

Value-Added Tax

In order to make the most of economic globalization, many DMCs have entered into

regional trade agreements or joined theWorld Trade Organization. Such trade

groupings require countries to reduce overall dependency on international trade taxes.

To compensate for lost international-trade tax revenue many countries have sought to

increase revenue derived from indirect sales taxes and one effective method for

achieving this goal is replacing turnover sales tax with value added tax. Turnover sales

tax doubly taxes consumers and is easily evaded. VAT, however, eliminates double

taxation, promotes business competitiveness, and is more compatible with a liberalized

trade regime.Within ASEAN, VAT collection has been very responsive to economic

growth. Many DMCs such as Cambodia, Thailand, and Viet Nam have relied primarily

upon VAT revenue to compensate for revenue lost due to tariff rate reductions. Since


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VAT requires systematic bookkeeping and accounting, tax authorities that wish to adopt

VAT must carefully design rules, laws, and administrative procedures to facilitate a

smooth transition.

They must also disseminate adeqate information so that all parties will know how to

fulfill VAT requirements. VAT should be introduced during the slowest time of the

business year to minimize transitional problems. Governments must monitor prices fixed

by large businesses to prevent them from using the introduction of VAT as an excuse to

raise prices unreasonably. The implementation of VAT is complex. Some governments

choose to exempt small businesses and financial institutions from VAT and instead

impose business turnover taxes. Thailand, for example, exempts from VAT goods that

are inelastic and necessary for the poor, such as unprocessed food, unprocessed

agricultural products, medicines, and textbooks. In spite of VATs clear advantages,

some countries in the Asian and Pacific region, including the Philippines and Thailand,

have encountered problems administering VAT because economic circumstances are

continually and rapidly changing. For example, certain transactions that are not subject

to or are difficult to assess for VAT have increased dramatically in recent years. These

include international business transactions, trade in services, and electronic commerce.

Since VAT was originally designed for application to the sale of goods in closed

economies, such developments present new challenges to tax administrators.

Policymakers must, therefore, constantly monitor the economic environment and adjust

VAT administration accordingly. The adjustments include tax base coverage, tax rates,

payment measures, and tax exemptions.

In designing tax reforms, tax authorities in developing countries should be aware of

taxation trends and practices in both developed and developing countries. The

experiences of developed countries can serve as a model of probable future tax trends

and thus enable tax authorities to prepare for the long and medium term. In the short

term, developing countries can also quickly adapt and implement complex tax

regulations and guidelines that developed nations have already designed and tested,

such as transfer pricing rules. Beyond this, developing countries can also learn other

valuable lessons from the recent experiences of developing nations. Such peer


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experience is especially relevant because all developing economies share the common

tax problems of large informal sectors and low ratios of taxpayers to total population.

In coping with the erosion of tax bases caused by globalization and technological

advancements, tax authorities in developing countries must adjust tax policies and

administrations to minimize revenue loss. First, tax administrations should rely more

heavily on indirect than on direct taxes, while moving from bilateral toward multilateral

tax agreements. Favoring indirect taxes, like value added tax, helps to broaden the tax

base, reduces overall tax rates, and thus lightens individual tax burdens and distortions.

By resorting more to multilateral tax agreements, countries can efficiently reduce the

likelihood of double taxation and tax competition among different tax administrations.

Second, to prevent multinational corporations from avoiding taxes by manipulating

transfer prices, tax authorities should adopt a form of the arms-length-pricing principle,

such as that used by the OECD. Essentially, this is one example of a legal reform

designed to prevent taxpayers from avoiding taxes by manipulating difference in tax

rates among different countries. Third, developing countries that have not already done

so should replace turnover sales tax with value added tax. Because VAT is broad-

based, governments can lower the tax rate and thereby reduce the overall excess

burden. Fourth, developing countries must implement effective good governance and

anticorruption programs in the realm of tax administration in order

to reduce tax leakages.

Double Taxation

Double taxation means taxing the same income twice, once in the home country and

again in host country. It is of relevance to mention here No rules of international law

prohibit international double taxation. So it is for the countries in the international arena

to solve double taxation problems. Double taxation of income is a great disincentive as

it

(i) Hampers free flow of capital and

(ii) Becomes a prohibitive burden on taxpayers leading to decline in foreign investments.


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Hence, negotiation of tax treaties between different countries became inevitable and

these have been entered in large numbers based on OECD and UN models with

suitable alterations, where necessary, to meet the special needs of the contracting

countries. These agreements are in the nature of contracts between the countries,

which have entered into such agreements.

Residence Vs. Source jurisdiction

In the concept of International taxation, there is a link- age between Sovereign (Taxing

authority), Subject Taxpayer) and Object (Income generating economic activity), some

countries tax the subject (tax payer) on his economic activity in the world. While some

other countries confine themselves to taxing economic activity in their respective

countries. This is called Status or residence jurisdiction and Source jurisdiction

respectively.

Scope of the tax treaties in determining jurisdiction

Normally tax treaty between two countries covers

(1) Persons

(2) Taxes

(3) Territory

(4) Time.

The treaty, generally applies to residents of the contracting states. Each country retains

the power to tax its citizens and residents on their world income (Status Jurisdiction)

and taxes others (non-citizens), (non-residents) only on their income in the country

(Source jurisdiction).

However, the treaty provisions protect the taxpayers from suffering double taxation on

the same income. The treaty provisions have no fixed duration and can be terminated

by a contracting state with six months notice after a treaty has been in effect for five

years. (U.S Model 1981 Act 29) The treaties can lessen the vigor of double taxation and

cannot enhance the burden.

Methods of avoiding double taxation

Countries throughout the world are following various methods of avoiding double

taxation.


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They are as follows.

(1) Unilateral relief

(2) Bilateral relief

(3) Multilateral relief

(4) Non-tax treaties

Unilateral relief:

Under this system of taxation whether the income is subject to tax abroad or not is

immaterial. In Unitary system, relief is given by way of tax credit for the taxes paid

abroad. The countries, which follow this method of tax credit, are, U.S, Greece, India,

and Japan to name a few.

For example, under section 91 of the Income tax Act, 1961,the method is tax credit

method. A resident in India who has paid income tax in any country with which India

does not have a treaty for the relief or avoidance of double taxation is entitled to credit

against his Indian Income tax for an amount equal to the Indian coverage rate or the

foreign rate whichever is lower applied to the

double taxed income. This is done as follows.

a.Where the foreign tax is equal to Indian tax, the full amount of foreign tax will be

given credit.

b.Where the foreign tax exceeds the tax payable in India, the liability to Indian tax will

be nil. However, no refund in respect of the excess amount is allowed, and

c.Where the foreign tax paid is less than the Indian tax after deducting the foreign tax

would be payable by the taxpayer. The principle is that the credit allowable will never

exceed the amount of Indian income tax, which becomes due or payable in respect of

the doubly taxed income.

Bilateral relief:

Bilateral relief may take any one of the following two forms. Firstly, the treaty may apply

exempting method, the country in question refrain from exercising jurisdiction to tax a

particular income. For ex, under this exemption method, the country of source in which

the Permanent Establishment (PE) is located is assigned an exclusive jurisdiction to tax


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the profits of the establishment. In turn it may agree to refrain from exercising its

jurisdiction to tax the owner

on these profits. Alternatively, the treaty may provide relief from double taxation by

reducing the tax ordinarily due in one or both of the contracting parties on that income

which is subject to double taxation.

For example, the country, which is the source of a dividend, often agrees to reduce the

withholding rate normally applicable to dividends paid to non-residents and the country

of residence agrees to give a tax credit or similar relief for the tax paid to the country of

source. In such a case, both the countries exercise the rights to jurisdiction, while

mutually agreeing for adjustments. This helps in avoiding or at least reducing the

international double taxation on the income in question. Many treaties combine both the

methods of relief.

Multilateral treaties:

These are similar to bilateral treaties. It is achieved through agreement between many

countries e.g. European Economic Community

Non-Tax treaties:

These are not direct treaties of tax, but are treaties of friendship, cooperation, political

ties, diplomacy etc. But which consequently result in tax consequences.

Position In India:

The Income tax Act, 1961 provides unilateral relief under sec: 91 of the Act. Besides,

the Central Government is empowered under Sec: 90 of the I.T Act to enter into an

agreement with a foreign Government, which may take any one of the above forms

discussed viz, bilateral, multilateral, non-tax treaty basis. It may be entered for any one

of the following purposes.

a. Double tax relief

b. Double tax avoidance

c. Exchange of information

d. Recovery of tax

According to Sec 90 (2) of the Indian Income tax Act, where the Central government

has entered into any such agreement, then the provisions of that agreement would

normally apply to the case of an assessee who is covered by such agreement.


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However, if the relevant provisions under the Indian Income tax Act are more beneficial,

then to that extent, the assessee can seek application of the provisions of the Act as

against the provisions of the agreement.

Sec.91- Relief if there is no DTAA

According to Sec 91 of the Indian Income tax Act, the following is the relief available if

there does not exist an agreement u/s 90 between India and the country in which the

income accrues.

If any person resident in India in any previous year establishes that he has paid income

tax by deduction or otherwise, in any country in respect of his income which accrued or

arose outside India, he shall be entitled to the deduction from the Indian income tax

payable by him such a sum calculated on such doubly taxed income at the Indian rate

of tax or at the rate of tax of the said country, whichever is lower. Where the tax rates

are equal, the Indian rate shall apply.

Foreign Tax Credit Of U.S

The United States has chosen the foreign tax credit method the method of allowance

of a credit against its own income tax for the income tax paid by the U.S tax payer to the

country of source-as the principal method of accommodation to be used in its

international tax relations.

The credit is given unilaterally in the Internal Revenue Code and is thus the key factor in

the code provisions relating to foreign income. These Foreign Tax Credits (FTCs) are of

two types called direct or indirect.

Direct Foreign Tax Credit:

A direct tax is one imposed directly on a U.S taxpayer. Direct taxes include the tax paid

on the earnings of a foreign branch of a U.S company and any foreign withholding taxes

deducted from remittances to a U.S Investor. Under section 901 of the U.S Internal

revenue Code, a direct foreign tax credit can be taken for these direct taxes paid to a

foreign government. Taxes that are allowable in computing foreign tax credits must be

based on income. These taxes would include foreign income taxes paid by an overseas

branch of a U.S corporation and taxes withheld from passive income (i.e.dividends,

rents, and royalties). Credit is not granted for non income-based taxes such as sales tax

or VAT.


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Indirect Foreign Tax Credit:

U.S corporate shareholders owning at least 10% of a foreign corporation are also

permitted under section 902 to claim an indirect foreign tax credit or deemed paid credit

on dividends received from that foreign unit, based on an appointment of the foreign

income taxes already paid by the affiliate. This indirect credit is in addition to the direct

tax credit allowed for any dividend withholding taxes imposed. The foreign dividend

included in U.S income is the dividend- received grossed up to include both withholding

and deemed paid taxes. In no case can the credit for taxes paid abroad in a given year

exceed the U.S tax payable on total foreign source income for the same year. This rule

is called the overall limitation on tax credit. In calculating the overall limitation, total

credits are limited to the U.S tax attributable to foreign source income (interest income

is excluded). Losses in one country are setoff against profits in others, thereby reducing

foreign income and the total tax credit permitted.

Thus,

Maximum total tax credit = Consolidated foreign profits and losses * Amount of

tax liability

Worldwide taxable income

If the overall limitation applies, the excess foreign tax credit may be carried back two

years and forward five years. The result of the carry back and carry forward provisions

is that taxes paid by an MNC to a foreign country may be averaged over an eight-year

period in calculating the firms tax liability.

OECDs Project on Improving the Solutions for Cross-Border Tax Disputes

As global trade and investment increases, the possibility of cross-border tax disputes

necessarily increases as well. Left unresolved, these disputes can result in double

taxation and a corresponding impediment to the free flow of goods and services in a

global economy. Both governments and business need effective procedures to keep

such disputes to a minimum and to resolve them satisfactorily when they arise. The

OECDs Center for Tax Policy and Administration (CTPA) has been actively involved in

developing procedures to deal with these issues. Looking to resolve tax disputes before

they start, the OECD has helped establish internationally accepted procedures for so-

called Advance Pricing Agreements (APAs) in which governments and taxpayers can


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agree in advance the appropriate approach to determine the arms length price to be

charged in transactions between related entities. Bilateral APAs (i.e. APAs involving the

competent authorities of the tax administrations affected by the transactions) create an

assurance in advance for taxpayers that a consistent approach will be taken by the

governments involved in a cross border transaction, thus avoiding the possibility of

costly later disputes. The work on avoiding disputes culminated in the publication of the

Annex to the OECD Transfer Pricing Guidelines on conducting APAs under the Mutual

Agreement Procedure of Article 25 of the OECD Model Tax Convention (MAP APAs).

Work has now moved on to focus on solving cross border tax disputes where they arise

and to broaden the scope to all treaty disputes and not just transfer pricing. The mutual

agreement procedure (MAP) provided foreign tax treaties, which follow the OECD

Model Convention, has been the traditional mechanism to solve these disputes. The

MAP allows tax authorities to meet together to attempt to resolve differences in a

manner that ensures that double taxation will be avoided and that there will be an

appropriate application of the convention. The MAP has worked reasonably well in the

past, but both the number of cross border disputes as well as the complexity of the

cases involved has increased. Improving the effectiveness of the operation of the MAP

and, equally important, assuring that the cases involved in the MAP process will come

to a satisfactory conclusion is the focus of an important new project at the OECD. The

OECDs Committee on Fiscal Affairs formed aWorking Group charged with examining

ways of improving the effectiveness of the MAP, including the consideration of other

dispute resolution techniques,

which might be used to supplement the operation of the MAP. The Working Group

consists of government officials with expertise in tax treaties and government officials

with expertise in transfer pricing. TheWorking Group is not expected to reach final

conclusions but will report the results of its work to the CFA. The first meeting has been

held and work is underway on gathering information from both business and

governments on how the existing MAP is working and how it can be improved. The work

covers both operational issues and substantive issues. Operational issues include

topics such as: the transparency of the procedures; the role of the taxpayer in the

process; the cost of the process; establishing a timeframe for settlement etc.


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Substantive issues include: the scope and purpose of Article 25; the interaction between

MAP and domestic law, constraints on the ability to use or implement the MAP, time

limits, suspension of tax and interest etc. Particular attention is being focused on ways

to ensure that the MAP process will reach a satisfactory conclusion and that the

conclusion is reached within a

reasonable timeframe. Under the existing MAP, if after the end of discussions, the

countries involved in a dispute cannot agree, the dispute remains unresolved and can

result in unrelieved double taxation. Further even if the case is agreed, the procedure

can sometimes take a long time and use a lot of taxpayer and tax administration

resources. Such results are unsatisfactory to all concerned. A number of supplementary

techniques are therefore being considered to deal with such situations. For example,

difficult questions which arise in the MAP could be submitted to a neutral mediator who

would help the parties to understand better the strengths and weaknesses of their own

case and the other partys case.

Abuse of Double Taxation Avoidance Agreements

The objectives of Double Taxation Avoidance/Credit agreements are only to avoid

double taxation on the same income. But it assumes that a taxpayer pays at least one

tax in a country. Taxpayers across the globe indulge in a number of methods to reduce

the tax by intelligence

and sometimes by illegality. They use tax avoidance devices generally by trying to

exploit the Double taxation avoidance treaties. This kind of tax avoidance takes place in

any one of the following manner:

1. Transfer pricing

2. Treaty Shopping

3. Misuse of DTAAs in tax havens

Treaty shopping

Under this method, the tax treaty agreements are misused by taking advantage in

investing in low tax countries. MNCs shop for DTA agreements signed by countries to

obtain fiscal advantages. Treaty shopping in India The most important treaty shopping

in which the Indian Government is losing considerable revenue is in the Mauritius route.

Indo-Mauritius DTA agreement came into effect from 6th Dec 1983. As per the


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agreement corporate entity if resident in Mauritius has the choice to pay income tax in

Mauritius at Mauritius tax rates even if the taxable income accrues in India. India can

only impose a law withholding tax of 5 percent of 15 percent on the dividend income

paid by the Indian Subsidiary to the foreign corporation. A foreign corporation,

incorporated in Mauritius can repatriate dividend income received from

an Indian Joint venture subsidiary with option to pay tax in Mauritius at Mauritius rates

of income tax instead of the very high corporate rate of income tax for foreign

corporations in India. Under the Mauritius Offshore Act a corporation known as the

MOBA entity has the privilege to pay income tax on dividend income (from India)

repatriated into Mauritius on a voluntary basis in the sense of paying at a rate choosing

from 0 percent to 35 percent. The following illustration will reveal how fiscal advantage

of the Mauritius route will be availed by the MNCs. Modus Operandi of MNCs is: MNC

Channels investment into India via subsidiary incorporated in Mauritius as a MOBA

corporation is issued a tax residence certificate by the Mauritius if such corporation

(a) has local directors

(b) holds board meetings in Mauritius

(c) Maintains a bank account in Mauritius and

(d) Maintains books of account in that country.

Thus a Mauritius residents in the MOBA subsidiary of the foreign company can choose

to pay tax on dividend income, repatriated out of India, under the Mauritius tax laws at

Mauritius tax rates. This is by virtue of Clause 13(4) of the Indo-Mauritius DTA treaty.

3. Misuse of DTAA in Tax havens:

Tax Haven Countries

A tax haven nation means a nation with nil or moderate level of taxation and /or liberal

tax incentives for undertaking specific activities such as exporting.

Types of Tax haven countries:

a. Nil tax haven countries

These have no taxation at all on income of any sort accrued from these nations. This

type encompasses many of the tax havens in the carribean, such as the Bahamas,

Bermudas and the Cayman islands. For Example, Bahamas levies a flat tax of 100$ per


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year on all Bahamian Companies. It has no tax treaty with any country require it to

disclose any information.

b. Nil tax outside haven countries

These impose tax on any income accruing from within its territory but exempt from tax

any income brought into the tax haven from outside. A country whose tax benefits are

characteristic of this type is Hong Kong. Although Hong Kong imposes a nominal tax of

15% on Hong Kong sourced income, foreign source income is completely exempt.

Panama is another good example of nil tax outside haven countries.

c. Low tax haven countries

Here, income is not exempted but taxed at lower rates. A good example for a country

representing this type of tax haven is The British Virgin Islands. It has a 12 % income

tax rate. Another example is the Netherlands Antilles, a colony of the Netherlands

located few miles

off the coast of Venezuela. Income taxes in these countries are very low, and there are

special tax privileges to shipping, aviation and holding companies.

d. Special Exemption tax haven countries

These are special exemptions, which are given in the form of a special act or

concessions to attract investment by MNCs. This group includes those countries that

are trying to promote development in certain regions or encourage industrialization

within the country. The most notable example here is the Republic Of Ireland, which

exempts from taxation the export earnings of corporations that setup manufacturing

operations in certain regions.

Factors that are to be considered by companies while choosing a tax haven

Before analyzing the type of tax haven to use, the MNC must develop a framework to

evaluate its projected needs against the advantages of the various tax havens. Factors

that are usually considered in choosing a tax haven include the following.

The political and economic stability of the country and the integrity of its Government.

The attitude of the country towards tax haven business.

The other taxes, aside from income taxes, it imposes.


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Tax treaties (Some tax havens owe their very existence to the fact that they are

parties to

advantageous tax treaty agreements)

The lack of exchange controls.

Liberal incorporation laws that minimize both the cost of incorporation and the length

of time it takes to incorporate.

Banking facilities.

Infrastructure facilities such as roads, telecommunication etc.

The long range prospects for continued freedom from taxation.

Forms of tax avoidance in tax havens

Multinational Corporations face a perennial charge for their misuses of tax havens to

shield income from the local tax collector. The tax avoidance in tax havens takes palace

broadly by

two methods.

a. Profit Diversion

b. Profit Extraction

Profit Diversion:

Under this, profit is diverted away from high tax jurisdiction into the tax haven thereby

avoiding income tax on the money thus diverted. For ex Company X, which is, a MNC

sells at a low price

to a subsidiary in a tax haven country that in turn sells worldwide the same product at

high prices.

Profit Extraction:

In this method, a company in a tax haven country renders services to a company in a

high tax jurisdiction and extracts money from that jurisdiction in the form of consultancy

fees, licensing fees, technology fees, royalty etc as being gross by inflated so that

effectively money is brought into the tax haven while the high tax jurisdiction subsidiary

claims these fees as deductible expenses. The OECD publishes from time to time a list

of tax havens based on their


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co-operation or non-co operation. OECD feels that the tax havens have distorted the

natural flow of international tax and funds It is for this reason that it has asked the tax

havens to match their tax rates with those of the OECD members.

as india continues to experience increased dosage of capital infusion

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