Administração Contábil e Financeira

FINANCIAL STRATEGIES FOR MINIMIZINGCORPORATE INCOME TAXES

UNDER BRAZIL/S NEW GLOBAL TAXSYSTEM

Stephen T. LlmbergVisiting Professor, Fundação Getúlio Vargas.

Professor, The University of Texas, Austin.E-mail: Iimberg@mai/.utexas.edu

John R. RoblsonProfessor, The University of Texas, Austin.

Michael S. SchadewaldAssociate Professor, University of Wisconsin,

Milwaukee.

Stephen Limberg grateful/y acknowledges the support of Phílips do Brasil Ltda. without which this research wouldnot have been possible. The authors also wish to express their appreciation for the valuable insights of Mr.Raimundo L.M. Christians from Price Waterhouse in São Paulo, Brazil.

RESUMO: Em 1996, o Brasil adotou um sistema internacional de impostos de renda para empresas. Este sistemarepresenta uma mudança fundamental em como o governo brasileiro trata as transações internacionais e asestratégias para minimizar os impostos para as empresas. Neste artigo, descrevemos as bases conceituais paraum sistema internacional de impostos e o problema causado pela criação de uma dupla taxação. As reações dogoverno e da iniciativa privada à dupla taxação são consideradas. Também são analisados os mecanismos imper-feitos desenvolvidos no Brasil e em outros países para atenuação da taxação dupla. Finalmente, abordamos asestratégias utilizadas pelas empresas para não apenas evitar a dupla taxação como também ter as vantagens dosparaísos fiscais.

ABSTRACT: In 1996, Brazil adopted a worldwide income tax system for corporations. This system represents afundamental change in how the Brazílian government treats multinational transactions and the tax minimizingstrategies relevant to businesses. In this enicte, we describe the conceptual basis for worldwide tax systems andthe problem of double taxation that they create. Responses to double taxation by both the governments and thepriva te sector are considered. Namely, the imperfect mechanisms developed by Brazil and other countries formitigating double taxation are analyzed. We ultimately focus on the strategies that companies utilize in order notonly to avoid double texetion, but also to take advantage of tax havens.

KEY WORDS: financiaI strategies, foreign tax credit, international tex, tax minimization, worldwide incometaxes system.

PALAVRAS-CHAVE: estratégias financeiras, taxas de crédito estrangeiras, taxas internacionais, redução deimpostos, sistema internacional de impostos de renda.

RAE - Revista de Administração de Empresas São Paulo, v. 37, n. 1, p. 41-52 Jan./Mar. 1997 41

Brazilian trade policies and trends continueto indicate ongoing intemationalization of itscommercial markets. One such sign of Brazil' sglobalization is its recent adoption of aworldwide (or global) income tax system forcorporations. Such a system is consistent withlongstanding policies of most developedcountries. The corporate strategic impact of thisnew system will become increasingly significantas Brazilian companies continue to look abroad.The purpose of this artic1e is to describe thenature and challenges associated with aworldwide income tax system, and identifycorporate strategies frequently undertaken tominimize an enterprise's global taxo

, . . . . . . . . . . . . . . . . . . "There is no global oufhority

fhof esfoblishes infernofionolfax rules. Thejurisdicfionol

scheme fhof o counfry odoptsspecifies lhe types of

relofionships wifh foxpoyersfhof lowmokers believe oresufficienf fo jusfify foxofion.

" . . . . . . . . . . . . . . . . . . . . . ,The first section develops the rationale

underlying the global income tax system inBrazil, as well as other countries. Such a systemoften leads to the possibility that one dollar ofearnings will be taxed by two or morejurisdictions, or so-called double taxed. Thesecond section describes govemment responsesto double taxation, inc1uding Brazil's responseand that of other countries. Double taxation isof concem to govemments because it might puttheir intemational businesses at a disadvantagein world markets. In the third section, weaddress the private sector's response to doubletaxation. By strategically managing globalstructures and finances, multinationals may notonly mitigate double taxation, but also use taxhavens to their advantage.

JURISDICTION TO TAX

At present, there is no global authority thatestablishes intemational tax rules. That is, thereis no intemational tax law per se, only nationaltax laws. Therefore, each country has discretionover deciding who and what to taxo In this

42

section, we discuss the type of connection usedby countries to establish the right to taxo

What gives a country tax authority? Thejurisdictional scheme that a country adoptsspecifies the types of relationships withtaxpayers that lawmakers believe are sufficientto justify taxation. Typically, taxation in acountry arises when a business entity isconnected to the country in one of two ways -namely, through a personal relationship or aneconomic relationship.

Personal relationship

A personal relationship with a countryfrequently leads to taxation. For individuals,such a personal relationship may be establishedby virtue of being a citizen or resident of acountry. Corporations, the subject of this artic1e,can also have a personal relationship with acountry through citizenship or residency. Acorporation is often considered a citizen of thecountry in which it is chartered. In somecountries, mere incorporation is enough toestablish tax authority, regardless of thecompany's activity Ievel in the country ofincorporation. Under the laws of other countries,incorporation does not, by itself, create taxauthority. In those countries, some minimumlevel of activity is required before a govemmentestablishes its right to taxo

Vntually in all countries, corporate residencyresults in taxation. Residency typically dependson where a company is managed and controlled.Not surprisingly, the interpretation of terms suchas "management" and "control" can take ondifferent meanings in different jurisdictions. Forexample, one interpretation might be based onthe location ofboard meetings whereas anotherinterpretation might look to the location whereday-to-day operations take place or the principalplace where the business is located. Becausedefinitions of residency vary with country, it ispossible for a taxpayer to be a resident of twojurisdictions. To avoid this redundancy manytax treaties between countries have so-called tiebreaker rules that determine a single residencylocation.

Economic relationship

An economic relationship with a countrymight also lead to taxation. For both individualsand companies, an economic relationship exists

© 1997, RAE - Revista de Administração de Empresas / EAESP / FGV, São Paulo, Brasil.

F/NANC/AL STRATEC/ES FOR M/N/M/Z/NC CORPORATE /NCOME TAXES ...

, .. .. . .. . . . . . . .. . .. .. .. .. .. .. .. . . '"

Before 1996, Brazll faxed fheincome of corporafíons under .

fhe ferritorial system oftaxation. Under fhis sysfem,

only tnose corporafíons hoving .an economia relofíonship wifh .

Brazil were faxed.. Thof i~Brazilían corporate cífízens

and resídenfs were allowed to .exclude foreígn sources'

income from domesficfaxafion. Beginning in 1996,

Brazll began faxíng lheíncome Df 8raziliancorporafíons under

a worldwide fax sysfem,

'" •• •• .• •• •• .• •• .• •• •• •• •• •• •• •• •• •• •• •• •• •• #

whenever they derive income from businessactivities or invest:ment assets located within acountry. Business activities usually create aneconomic relationship if a nontri via] part of thevalue added process occurs in a country, suchas manufacturing, marketing, or distributionfunctions. Strict importing and nominalactivities usually do not create an economicpresence in a country, The set of entities derivingincome from sources within a country includesnot only citizens and residents (those personswho already have a personal relationship withthe country), but also foreigners.

Brazil's worldwide tax system

Before 1996, Brazil taxed the income ofcorporations under the territorial system oftaxation. Under this system, only thosecorporations having an econornic relationshipwith Brazil were taxed. That is, Braziliancorporate citizens and residents were allowedto exclude foreign sources ' income fromdomestic taxation. Under the territorialsystern, Brazil (the home country) assertedprimary jurisdiction over domestic incomewhether the recipient of that income was acitizen, resident, ar foreigner. Primaryjurisdiction is the right to tax incomeirrespective of the jurisdictional c1aims ofother countries. No jurisdiction was asserted

RAE • v.37 • n. 1 • Jan./Mar. 1997

over income derived from abroad.Beginning in 1996, Brazil began taxing the

income of Brazilian corporations under aworldwide tax system. In general, countriesunder this system impose tax based on bothan economic and a personal relationship.Therefore, a foreign branch still has a personalrelationship with the home country because iris merely a unit of the home company.Accordingly, a foreign branch's income willbe taxed by the home country on the accrualbasis, even if the income is not repatriated tothe home office. On the other hand, a foreignsubsidiary is a separate legal entity, hence ithas no personal relationship withits parent'shome country. Moreover, if it only earnsincome abroad, it has no economic relationshipwith its parent's home country. Accordingly,the income of a foreign subsidiary general1y isnot taxed at home until ir is repatriated to theparent as, for example, dividends. The type oftax systems used by a sample of countries isshown in Exbibit I.

Exhibit ISample of Countries with Corporate

Territorial versus Worldwide (WW) Tax Systems

AsiqCountry System

Hong Kong TerritorialJapan WWKorea WWSingapore WWThailand WW

EuropeCountry System

France TerritorialGermany WWNetherlands WWPoland WWU.K. WW

North AmericaCountrv System

Canada WWU.S. WWMexico WW

Laftn ArnericoCountry System

Argentina WWBrazil WWChile WWCosta Rica TerritorialVenewela Territoriai

As suggested by Exhibit 1, the worldwidetax system dominates among the world'slargest trading countries. By adopting thissystern, Brazil joins the ranks of tbesecountries, However, Brazil added a uniquevariation in its original enactment of aworldwide system, It not only accrues incomefrom foreign branches, but it also accruesincome from foreign subsidiaries. I About sixmonths after the enactrnent of this law anotherBrazilian tax pronouncement took a differentposition. It allowed taxation of a foreign

1. Law 9.249/95. Arlicle 25.December 26, 1995 eflectiveJanuary 1, 1996.

43

2. Instrução Normativa 38. Article2, Section 1. June 28, 1996.

3. $40 = $60 foreign source income- $20 foreign taxes paid

4. The limited, as well as unlimited,FTC systems typically provide acredit only for foreign direct taxes,namely incometaxes. Because theyprovide no relief for foreign irx:lirecttaxes, for example value addedtaxes, they are bias against foreigninvestments in countries with largeindirect taxes.

44

subsidiary's income based on the moretraditional non-accrual approach, namelyonly when the income is repatriated."However, arguably this pronouncement doesnot carry the weight of law. Accordingly, asof this writing, it might be possible fortaxpayers to operate under the law or thepronouncement creating an anomaly that isdiscussed later under the title "tax havens",

Under the worldwide tax systemmultinational corporations are likely to faceinternational double taxation. A foreignbranch's income is frequently taxed in theforeign country based on an economicrelationship and the same income is taxed asaccrued in the home country based on apersonal relationship. Likewise, a foreignsubsidiary's income is typically taxed abroadbased on an economic and personalrelationship with the foreign country. Thesame income is taxed when repatriated to theparent, and under Brazilian law it rnight evenbe taxed on the parent as accrued.

As a result, a fundamental issue faced bygovernments using a worldwide tax system ishow to rnitigate international double taxation.Both the home and the host countries mustdecide whether and how to adjust their taxsystem when there are competingjurisdictionalclaims. Commonly, double taxation ismitigated by countries acting alone(unilaterally) and, in some cases, they acttogether (bilaterally) through tax treaties.

GOVERNMENT RESPONSE TODOUBLE TAXATION

Unilateral mechanisms

Traditionally, it has been up to the homecountry to solve the double taxation problemof its corporation citizens and residents. Thereare several ways by which a country maymitigate double taxation. In all cases, thehome country is, fully or partially, forfeitingits jurisdictional tax c1aim on the foreignsource's income. Brazil's pre-1996 use of aterritorial system for corporations is one wayof avoiding double taxation.

Alternatively, under a worldwide taxsystem, corporations may be allowed to deductthe foreign taxes they pay from their tax baseat home. However, this provides only partialrelief from double taxation. For example,

assume a company pays $20 in foreign taxeson $60 of a foreign branch's earnings. Whenthe $60 of foreign earnings is considered astaxable inccime back home, a $20 deductionfor foreign taxes paid still results in a hometax base of $403 from foreign income. In otherwords, $40 is still double taxed. For thisreason, countries usually do not relyexc1usively on this deduction mechanism.

Another worldwide mechanism by whicha home country can mitigate double taxationis to inc1ude all their home and foreign incomein the tax base, but allow an unlirnited foreigntax credit (FTC), or domestic tax offset, equalto the foreign income taxes paid. If the FTCis unlirnited, foreign income taxes paid offsetthe home country income tax, even if the hostcountry tax rate exceeds that of the homecountry. The home country still asserts primarytax jurisdiction over domestic corporateincome, but only secondary jurisdiction overthe foreign income. The c1aim is secondary inthe sense that the home country forgoes theright to collect taxes to the extent thecorporation's foreign income is taxed by thehost country. However, because foreign taxesin excess of home taxes (on foreign income)offset taxes on domestic income, this methodis not adopted by countries very frequently.

Brazil , like most countries using aworldwide tax system, has adopted a limitedFTC. Like the unlimited FTC, the mechanicsof a limited FTC can be complicated.However, the following conceptualinterpretation is sufficient to capture criticalaspects of the lirnited FTC. In essence, if thehome tax rate is greater than the foreign taxrate, the FTC equals the foreign taxes paid.This is no different than the unlimited FTC.However, if the home tax rate is less than theforeign rate, the FTC is limited to thedomestic tax on the foreign income.Therefore, conceptually this credit is thelesser between (a) the foreign taxes paid or(b) the domestic taxes on the foreign source'sincome." Application of this concept isillustrated below.

• Base case - no FTC. Assume, forexample, that Bco is a Brazilian corporationwith a foreign branch in country F. Forsimplicity assume Bco's annual taxable incomeis $100, of which $40 is earned in Brazil and$60 in F. Brazil's corporate income tax rate is25 percent, and F's rate is 35 percent. Brazil

RAE • v.37 • n.1 • Jan./Mar. 1997

FlNANClAL STRATEC/ES FOR M/N/M/Z/NC CORPORATE /NCOME TAXES ...

and F use the same rules for computing andsourcing taxable income.'

If Brazil provides no mechanism formitigating double taxation, then the fullamount of Bco 's foreign income may be taxedby both Brazil and F, as follows.

Bco's Brazilian Tax Relurn Bco's Counlry F Tax Relurn

F source incorne $ 60 F source incorne $ 60

+ Brazilian incorne 40 + Brazilian incorne na

= Taxable incorne .$100 = Taxable incorne $ 60

x Tax rate 25% x Tax rate 35%

= Brazilian lax $ 25 = Flax $ 21

na = nolapplicable

Taxations in Brazil and F combine for atotal tax of $466 on Bco's earnings of $100,for an overall tax rate of 46 percent. 7 Bco' sforeign source' s income of $60 is double taxed,resulting in a total tax rate of 60 percent" onthis income. The following subsectionsillustrate the concept underlying the lirnitedFTC mechanism Brazil and many othercountries use to rnitigate this double taxo

• Excess credit case. By allowing aFTC for foreign taxes that is lirnited to thedomestic tax on foreign income, Brazilelirninates Bco's double tax in the base case.Applying the concept above, this credit is thelesser between (a) $21 of F taxes paid or (b)$159 of Brazilian pre-FTC tax on F income.As shown below, the resulting $15 FTC leavesBco with a domestic tax liability of $1O,whichrepresents the Brazilian tax on Bco's $40 inBrazilian income.

Bco's Brazilian Tax Relurn Bco's Counlry F Tax Return

F source incorne $ 60 F source incorne

+ Brazilian incorne ...... 40 + Brazilian incorne

= Taxable incorne ..... $100 = Taxable incorne

x Tax rate 25% x Tax rate ..

$ 60

na

$ 60

35%

$ 21= Brazil pre-Flf tax S 25 = F tax

= FTC for F taxes $ 15

= Brazilian tax $ 10

na = nolapplicable

RAE • v. 37 • n. 1 • Jan./Mar. 1997

Taxation in Brazil and F combine for atotal tax of only $31 \O on Bco's earnings of$100, hence an overall tax rate of 31 percent. 11

Bco's foreign income of $60 is taxed onlyonce, albeit at the higher foreign rate of 35percent. The $6 difference between the $21paid to F and the $15 FTC allowed is calledan excess credit. It represents a foreign taxcost for which Bco received no benefit on itsBrazilian tax returno

• Short credit case. Assume now thatBco's branch is in country L where the tax rateis only 15 percent. The following worldwidetaxes result.

Bco's Brazilian Tax Relurn Bco's Country L Tax Return

L source incorne $ 60 L source incorne .. ...... $ 60

+ Brazilian incorne 40 + Brazilian incorne na

= Taxable incorne $100 = Taxable incorne $ 60

x Tax rate .. 25% x Tax rate ... 15%

= Brazil pre.FTC tax $ 25 = L tax $ 9

FTCfor L tax $ 9

= Brazilian tax $ 16

na = nolapplicable

Taxation in Brazil and L combine for a totaltax of only $2512 on Bco's earnings of $100and an overall tax rate of 25 percent. 13 Inessence, Brazil allows Bco to reduce its $1514

domestic tax on L source's income taking intoaccount the $9 already paid to L. The resulting$615difference paid to Brazil is referred to as ashort credit because Bco is short of, namelylacks, $6 paid as foreign taxes, that could beused to offset domestic taxes on the foreignsource' s income.

• Cross crediting. Excess creditsrepresent a potential tax savings in the homecountry. Therefore, companies frequentlymanage their excess credits to derive fullbenefit from them. An effective strategy formanaging excess credits is to combine themwith short credits. This may be possible if acompany operates in at least two foreigncountries, one with an income tax rate abovethe home country' s rate and the other with arate below. For example, the following taxresults if Bco derives half ($30) its foreignsource' s income from country F and the otherhalf ($30) from country L.

5. This assumptian simplifies theanalysis but may be invalid in manyinstances since there are oftennumerous diflerences between howtwo countries define and sourcetaxable income.

6. $46 = $25 Brazilian tax paid + $21F tax paid.

7.46% = $46 worldwide taxes paid /$100 worldwide income.

B. 60% = 35% F tax rate + 25%Brazilian tax rate.

9. $15 = 25% Brazilian tax rate x $60F source income.

10. $31 = $10 Brazilain tax paid +$21 F tax paid.

11.31% = $31 worldwide tax paid /$100 worldwide incorne.

12. $25 = $16 Brazilian tax paid + $9L tax paid.

13.25% = $25 worldwide tax paid /$100 worldwide income.

14. $15=$60 Lsource incomex 25%Brazilian tax rate.

15. $6 = $15 Brazilian tax paid • $9FTC.

45

Bco's Brazilian Tax Return Bco's Country F Tax Return Bco's Country LTax Return

L source income $ 60 F source income $ 30 L source income $ 30

+ Brazilian income 40 + Brazilian income na + Brazilian income na

= Taxable income $100 = Taxable income .. $ 30 = Taxable income $ 30

x Tax rate 25% x Tax rate 35% x Tax rate 15%

= Brazil pre-Flf tax $ 25 = F tax $10,5 = Ltax $ 4,5

• FTC for F & L taxes $ 15

= Brazilian tax $ 10

na = not applicable

16. $25 = $10 Brazilian tax paid +$10.5 F tax paid + $4.5 L tax paid.

.17. 25% = $25 worldwide tax paid /$100 worldwide income.

18. $15 = $10.5 F tax paid + $4.5 Ltax paid.

19. $15 = $60 foreign (F + L) sourceincome + 25% Brazilian tax rate.

20.25% = ($10.5 F tax paid + $4.5 Ltax paid) / $60 foreign (F + L) sourceincome.

46

Bco's tax is only $2516 on worldwideeamings of $100. This is less than the $31worldwide tax when all $60 of Bco's foreigneamings were from F (excess credit case), andequal to the worldwide tax when all of Bco'sforeign eamings derived from L (short creditcase). In other words, Bco can operate in Fand still enjoy an overall tax rate of only 25%17even though the tax rate in F is 35%.

What enables this outcome? Recall thatconceptually the FTC is the lesser between(a) the $1518foreign tax paid or (b) the $1519

domestic tax on the foreign source income. Ineither case the FTC is $15. By combining thetaxes paid in F and L the average foreign taxrate is 25 percent," or equal to the domestictax rate on foreign income. In essence, crosscrediting allows companies to use a weightedaverage foreign tax rate while computingforeign taxes. In this case, this average rate isequal to the domestic rate. Therefore, the entiredomestic tax on foreign income is offset bythe FTC.

To prevent this type of cross crediting somecountries, such as the United Kingdom, applya so-cal1ed country-by-country FTC limitation,which prevents the taxes paid in one foreigncountry to be combined with those of anotherforeign country. Under this system, crosscrediting can still apply within a country ifdifferent tax rates apply to different types ofincome, such as operating income and interestincome. Other countries, such as the UnitedStates of America, allow taxes paid acrosscountries to be combined, but only for separateclasses, or baskets, of income. For example,taxes paid across countries can be combinedfor operating income, but this basket of taxesmust be kept separate from taxes paid on

passive income, such as interest and dividendincome. At the present time, Brazil has neithera country-by-country or income basketlimitation.

The cases above are based on the operationof foreign branches. However, intemationalactivities are commonly undertaken throughforeign subsidiaries. In this case, a foreignsource's income typically is only taxed whenrepatriated, for example through dividendspaid to the domestic parent. The principlesillustrated above still apply, but with an extradegree of flexibility. Namely, the parent candecide when dividends will be paid, hencewhen foreign eamings are subject to domestictaxes. Effective cross crediting strategiesshould balance the timing and amount offoreign dividends to minimize excess taxes,thereby minimizing taxes. For example,assume the foreign entities in the crosscrediting example above are foreignsubsidiaries ofBco instead offoreign branches.Bco's tax minimizing strategy is to payequivalent dividends from F and L in the sameyear leading to the same result illustratedabove.

Bilateral mechanisms

Territorial systems, or deductions and/orFTCs under worldwide tax systems representunilateral solutions to intemational doub1etaxation in the sense that they are created byindividual countries (and multilateral solutionsin the sense that they apply to outboundtransactions involving any foreign country).As another means of preventing intemationa1double taxation, countries also enter in tobilateral tax treaties only applicable to the twocountries that are party to the agreement.

Tax treaties contain provisions that reducethe tax imposed on income derived bycorporate (and individual) citizens of one treatycountry from sources within the other treatycountry. For example, country A may agree toforgo the tax on dividend income derived fromwithin its borders by citizens of country B inexchange for the reciprocal treatment bycountry B. The effect of such treaty provisionsis to give the home country primary taxjurisdiction. This is just the opposite effect ofunilateral techniques in which the homecountry usually relinquishes primary taxjurisdiction.

RAE • v. 37 • n. 1 • Jan./Mar. 1997

FINANClAL STRATECIES FOR MINlMIZINC CORPORATE INCOME TAXES ...

Therefore, under treaties a larger share ofthe tax on intemational transactions is savedfor the home country by subordinatingjurisdictional c1aims based on economicrelationships to c1aims based on personalrelationships. Of course, the increase in thehome country's tax revenues comes at the hostcountry' s expense. As a consequence, tax treatyprovisions are uniformly reciprocal in nature.

The shifting of primary jurisdiction to thehome country also explains why tax treatiesfrequently do not exist between developed anddeveloping countries. Developing countriesoften play host to foreign investment. Theydo not want to relinquish their right to tax theseinvestments by shifting their primaryjurisdiction to the (foreign) home country aswould occur under conventional treaties. Thisis especially true because, with limitedoutbound investment, developing countriesgain little by the reciprocal provisions intreaties.

Treaties are crafted to meet the specificobjectives of the negotiating countries. Oneprototype document for starting treatynegotiations is the 1994 model treaty of theOrganization for Economic Co-operation andDevelopment (OECD).21 Forerunners of thisinfluential model treaty are the 1992, 1977 and1963 OECD model treaties, and 1921 studiesby the League of Nations, (the OECDantecessor) that culminated in the first modeltreaty.

In 1980, the United Nations (UN) alsodeveloped a model treaty most distinguishedfor supporting tax authority based on incomesource, namely economic relationships. TheUN treaty is frequently the starting point fornegotiations to many Latin American countriesinc1uding Brazil. This is because itacknowledges the tax rights of developingcountries over income derived from them byricher capital exporting countries.

For example, the UN model treatyincreases the likelihood that a business willbe considered to have a so-called permanentestablishment in another country. In essence,a permanent establishment is the term usedto describe the level of economic activity ina host country that justifies taxation by thehost country." For example, to create apermanent establishment associated with abuilding site and consultant services, 12months of activity are required under the 1994

RAE • v. 37 • n. 1 • Jan./Mar. 1997

OECD treaty, but only six months arerequired under the 1980 UN treaty.Accordingly, a foreign building contractor inBrazil would be subject to Brazilian taxesafter only six months of activity under theUN model, whereas under the OECD model12 months of activity are required. It is nowonder the UN model is preferred. Likewise,whereas maintaining inventory for deliveryand having independent agents in a foreigncountry do not constitute a permanentestablishment under the 1994 OECD treaty,they do under the 1980 UN treaty.

, . . . . . . . . . . . . . . . . . . . . . ,Privafe sector respons« af a

mmtmom. affempfs to mifígafelhe impad of double faxafíonand frequenfly sfrives fo takefax advanfage of so-called fax .

bavens. Theseefforls areaffribufable fo fhe fax

problems and opporfunifiescreafed by fax inconsisfencíesacross counfries and fhe rapid

accelerafíon ofinfernafionalized markefs fhaf

began in fhe 1980's." . . . . . . . . . . . . . . . . . . . . . ,

In theory, the slightest economic relationshipwith a host country is enough to create the rightfor that country to impose taxation. Byexempting nominal economic activities fromhost country taxation, permanent establishmentprovisions facilitate administration and reducetrade inhibiting regulation.

COMPANV RESPONSE TO DOUBLETAXATION23

Private sector response, at a minimum,attempts to mitigate the impact of doubletaxation and frequently strives to take taxadvantage of so-called tax havens. Theseefforts are attributable to the tax problems andopportunities created by tax inconsistenciesacross countries and the rapid acceleration ofintemationalized markets that began in the1980's.

21. OECO COMMITTEE ON FISCALAFFAIRS. Model tax convention onincome and capital. Article 9(1).OECO publication service, March1994.

22. More specilically, the OECOtreaty indicates that a permanentestablishment includes a place 01management, a branch, an oflice, alactory, a workshop, and naturalresource extraction lacilities. Apermanent establishment does notinclude a loreign enterprise's use 01a lacility solely lor the purpose 01storage, display, or delivery 01goods;maintenance 01 a stock solely lorstorage display, delivery orprocessing; maintenance 01 a lixedplace 01 business solely lorpurchasing goods collectinginlormation, preparatory or auxiliaryactivities or a combination 01ali theseitems 50 long as the activity is 01 apreparatory or auxiliary character.OECO COMMITTEE ON FISCALAFFAIRS. Model tax convention onincome and capital. , Article 5(2),(3)and (4). OECO publication service,March 1994.

23. For a more detailed discussion01 selected concepts in this sectionsee OGLEY, A. The Principies ofInternational Tax: A MultinationalPerspective. Interlisc Publishing,1995.

47

Mitigating double taxation

• Avoid connection. An obvious methodcompanies might use to mitigate doubletaxation is to avoid a connection altogetherwith a host country. For example, acting at alevel of business below that of a permanentestablishment is one approach in order to avoidsuch a connection. Another, more complexmechanism applies when there is cross-boarderownership of a multinational enterprise asshown in Exhibit 2.

Exhibit 2Common Global Organization

Home Country I I Host Country,'============:

OperatingSubsidiaries

A foreign investor in a host country mayhave direct ownership in, hence recei vedividends from, a parent corporation in thehome country. At the same time, the parentmay be deriving a substantial amount of itsprofit from an operating subsidiary in the hostcountry. The structure shown in Exhibit 2 canbe modified to minimize the number ofjurisdictions through which dividends passoSuch a modification often strives to accomplishat least two objectives. First, it endeavors togive foreign shareholders direct access to profitsgenerated by subsidiaries located in theircountries. Even if subsidiaries and foreignshareholders are in different tax jurisdictions, itmay seek to by-pass the parent corporation if itadds an extra tax jurisdiction. Second, thesestructures attempt to maintain managementcontinuity and ownership control through theparent. In general, those strategies modifyExhibit 2 so it appears as in Exhibit 3.

As shown in Exhibit 3, a structure that

48

Exhibit 3Restrudured Global Organilation

Home Country I I Host Country,'=======~

results in some form of direct ownership of aforeign subsidiary by foreign shareholders maykeep dividend payments in one jurisdiction. Thespecific approaches taken to accomplish thisoutcome involve so-called stapled stocks,income or dividend access schemes, and otherrelated schemes that are broadly labeled ashybrid structures. The tax advantages ofthesestrategies must be weighed against theirpossible disadvantages which inc1ude potentialcomplexity, anti-avoidance measures thatgovemments may enact, and potential increasedrisk to shareholders that may result in discountedstock values,

A stapled stock structure requires aforeign shareholder to own shares in twocompanies that are traded together. Theforeign shareholders' dividends are likely toflow from only one of the two companies,preferably the company that is located in theshareholders' jurisdiction ar a jurisdictionthat has favorable tax agreements with theshareholders' jurisdiction. The Nestle groupdepicted in Exhibit 4 reflects a well knownexample of the stapled stock structure.

Unilac equity issued two types of stock,namely founders' shares and (dividend) bearershares. Only founders' shares had votingrights and they were owned in trust. NestIecontrolled Unilac as a beneficiary of the trust,and through representation on the Unilac boardof directors. This provided control andmanagement continuity for the group.Panamanian shareholders owned Unilac bearershares which had beneficial rights to dividends

RAE • V. 37 • n. 1 • Jan./Mar. 1997

F/NANC/AL STRATEC/ES FOR M/NlM/Z/NC CORPORATE /NCOME TAXES ...

Exhibit 4Stapled Stock

lhe Nestle Group

$wilzerland Penemo

•. Bearer shares

and distributions in liquidation (no votingrights), but only if they were held and tradedconcurrently with Nestle voting shares, bearingthe same serial number. Through this structureUnilac shareholders were able to receivedividends directly, instead of through Nestle,and at the same time continue to have a votein Nestle. Shareholders who were neitherSwiss or Panamanian could still benefit fromholdi..ngbea.rer shares to the extent that profitsearned in, and dividends earned from, Panamawere more favorably treated than those fromSwitzerland.

Income and dividend access schemes grantforeign shareholders of the parent corporationrights to recei ve profits directly from a foreignsubsidiary. As with stapled stock strategies,preferably the subsidiary is located in theforeign shareholders' jurisdiction. Onemechanism for achieving this outcome is tosee that income access shares of the foreignsubsidiary are issued to the foreignshareholders residing in the subsidiary'sjurisdiction. These shares are simply incomerights, and may or may not be stapled to sharesof the parent. Altematively, a trust may beestablished to hold income access shares. Theforeign shareholders may be named as trustbeneficiaries, and they may elect to receivedividends from the foreign subsidiary in lieuof dividends from the parent.

Hybrid structures is a catch-all termcapturing all other schemes that attempt to

RAE • v. 37 • n. 1 • Jan./Mar. 1997

minimize the number of jurisdictions throughwhich dividends flow. For example, dividendand liquidation rights in foreign subsidiariesmight be held by residents of the foreignjurisdiction while voting power is held by theparent directly or indirectly through a holdingcompany. Alternatively, companies indifferent jurisdictions might be completelyheld by local citizens, but bound together bya so-called equalization agreement. Underthis type of ownership, a reciprocal agreementrequires that the two companies must payequal dividends and equal distributions uponliquidation.

• Divert or extract profits. If a companyis economically connected to a host country,taxable profits may be diverted away from thehostjurisdiction. More specifically, taxes maybe minimized in a host country by minimizingtaxable profits through intercompany transferpricing on goods, services and rights. Forexample, a company subject to high taxes cancharge a low price for goods transferred to arelated company in a low tax country. Thelow price will minimize taxable income, hencetaxes, for the selling company. Of course, amultitude of nontax considerations may alsodictate transfer prices, such as the impact ofthe related party' s transfer prices on cash flows,bonus-based compensation, marketpenetration strategies, duties, anti-dumpingrules, and exchange controls, In addition,govemment's have increasingly enacted andenforced regulations that restrict transfer pricesbetween related entities."

When profits cannot be diverted throughtransfer pricing of goods, the focus turns toextractíng profits in other tax deductibleways. For example, a parent may capitalizeits highly taxed foreign subsidiary with debt.Accordingly, profit extraction can take theform of tax deductible interest payments tothe parent by the subsidiary, thus reducingthe subsidiary's taxable income and taxes.However, ex.cessive debt capitalization maybe challenged by taxing authorities.

Other forms of tax deductible paymentsfrom host country subsidiaries may inc1uderoyalties, rents, service fees, and insuranceprerniums, to name a few. Proper valuation ofthese deductible transfers still faIls under thepurview of transfer pricing. Moreover,companies must be aware that payments ofitems such as interest and royalties (as well as

24. See, for example, LlMBERG,S.T., ROBINSON J.R. andCHRISTIANS, R.L.M. InternationalTransfer Pricing S/ra/egies forMinimizing Global Income Taxes.Working paper, Fundação GetúlioVargas, São Paulo, Brazil. November1996; and LlMBERG, S.T.,ROBINSON J.R. and CHRISTIANS,R.L.M. Inlernational Transfer PricingRes/ric/ions: Impact on OotporeteFinanciai Policy. Working paper,Fundação Getúlio Vargas, São Paulo,Brazil. November 1996.

49

25. OECD COMMITTEE ONFISCAL AFFAIRS. Model taxconvention on income and capital.Artieles 10(4),11(4), and 12(3).OECD publication service, March1994.

50

dividends) may be subjected to so-calledwithholding taxes by the country ofdisbursement, Withholding taxes are chargedon payments such as those when they leavethe host country. Bilateral tax treaties reduceor eliminate withholding taxes between treatycountries, Therefore, an extensive network ofbilateral treaties may be a valuable taxplanning tool.

• Distributions. lf multi ple jurisdictionscannot be avoided and profits cannot bediverted or extracted then distributions fromhost jurisdictions rnay be considered whenfeasible. Tax benefits from distributions ariseif taxes are lower in the home country, henceenabling a higher after-tax return on futureearnings. Tax costs associated withdistributions include withholding taxes andincome taxes in the distributee's country.

Withholding taxes are frequentl yminimized by so-called treaty shopping. Thatis, if withholding tax rates are high between aparent and foreign subsidiary, the subsidiarymay be owned by a holding company in anintermediate country that has low treatywithholding rates. Taxes may be minirnizedon distributions to the holding company. Alow treaty withholding rate between theinterrnediate country and the parent's countrymay enable the funds to finaUy be distributedto the parent at a favorable withholding taxrate. Altematively, the funds may be parked,or left, in an intermediate country. As will bemore discussed in the next section, this hasspecial appeal if the intê§t diate country is atax haven in which no or low taxes apply toearnings within the country,

Of course, a number of nontax factors wiJlalso influence distríbution decisions, such asthe subsidiary's need forreserves, and politicaland exchange risks associated with retainingprofits in the subsidiary. In addition, countriesare increasingly adopting anti-treaty shoppingprovisions in their bilateral agreements. Forexarnple, the OECD model treaty requires thatfavorable treaty withholding rates will notapply unless the rccipient of dividends, interestand royalties, is also the beneficiary owner,rather than just an intermediary."

• Acquisitions andDisposals. Successfulimplementation of the strategies above willdepend on how an international acquisition isstructured. Planning is likely to involveappropriate forrns of capitalization (debt versus·

equity), assets acquisition (through stock versusbundled or unbundled asset purchases),consideration surrendered (cash versus stock),and entities chosen (branches versussubsidiaries). After acquiring and operating aninternational enterprise, its disposal ultimatelymay be at issue, Disposals are likely to attracttax in at least one jurisdiction inc1uding the home(parent's) country, host (subsidiary's) country,and intermediate countries, if any,

TAX HAVENS

As corporations continue to globalize taxhavens become more attractive.Fundamentally, there are two types of taxhavens as shown in Exhibit 5.

Exhibit 5Tax Havens Types

Type Iox Trealies Exomples

Jersey,Madeira Island

No ar No ar Bermuda,

low fax limiled Caymans Islands,frealies Netherlands Antilles,

ond Cook Islands

Normal fax TreatyHong Kong, Ireland,

with Luxembourg, Netherlands,

preferencesnetwork Singapore, and

Switzerlond

One type of tax haven is characterized byno ar low taxes. Recall that tax treaties usuallycontain a reciprocal agreement under which ahost country surrenders various rights to thetax treaty partner companies. Because thistype of tax haven has no OI Iow taxes tosurrender, it has littIe to offer a potential treatyparrner. Accordingly, these countries typicallyhave a low or limited network of intemationaltax treaties. However, there are notableexceptions. For example, many countries thathave a tax treaty with the Netherlands haveextended ir to the Netherlands Antilles, a partof the NetherIands Kingdom. SimilarIy,treaties with Portugal inc1ude its tenitory ofMadeira Island which has no income taxes.

A second type of tax haven has normaltaxes, but with significant preferences. Forexarnple, manufacturers receive substantial taxpreferences if they are located in Ireland.Further, Dutch domestic tax law excludes taxeson dividend income, capital gains, and incomefrom overseas branch . Moreover, there is no

",)J-,

RAE • v. 37 • n. 1 • Jan./Mar. 1997

FINANClAL STRATECIES FOR M/NlM/ZINC CORPORATE /NCOME TAXES ...

withholding tax on royalties or interests, anddividend withholding taxes are low, Becausetax haven countries of this type have a normaltax systems, albeit with preferences, theyfrequent1y have an extensive network of taxtreaties.

Desirable nontax attributes of a tax haveninclude qualified personnel; communicationscapabilities; a location preferably within aconvenient time zone; a legal and regulatoryenvironment in which, for example, propertyrights are protected and obligations arehonored; no exchange control restrictions;political stability; and confidentiality. Exhibit6 displays a common structure of holdingcompanies (HCs) in the Netherlands andNetherland Antilles (NA) used to minimizewithholding (WH) taxes.

Exhibit 6Tax Havens Characteristics

Exhibit 6 assumes that a parent company(Parent) has an operating subsidiary (Sub)abroad. Under alternative 1, Parent directlyowns Sub. Because there is no tax treatybetween the Parent's country and the Sub'scountry, a 25 percent withholding tax appliesto direct distributions. Under alternative 2,Parent owns Sub through a Netherlandsholding company (Dutch Holding) and aNetherlands Antilles holding company (NAHolding). Distributions from Sub to DutchHolding are exempt under domestic Dutch law,Distributions from Dutch Holding to NAHolding are subject to low withholding ratesby agreement between the Netherlands andNetherlands Antilles." Ifthe Parent's countryhas a tax treaty with the Netherlands Antilles,distributions from NA Holding to Parent aretaxed at low or zero rates as represented bythe zero withholding rate shown in Exhibit 6.Tnshorr, alrernative 2 saves Parent withholdingtaxes of 20 percent" on its distributions.

Mindful that flourishing tax planníngopportunities have accompanied the rapidgrowth of intemational trade and tax havens,govemments have enforced a variety of anti-

RAE • v. 37 • n. 1 • Jan./Mar. 1997

avoidance legislation which may be broadlycategorized into the following four goups.First, required administrative consent orexchange controIs have been used to restrictforming entities in, or shifting profits to, a lowtax jurisdiction. Second, mechanisms thatprevent tax free or deferred accwnulations ofprofits in tax havens are often enacted. Third,to the extent profits are being shifted to taxhavens by means of transfer pricing, it hasalready been noted that transfer pricíng hasbeen the subject of significant evaluation bymany tax authorities. Fourth, steps have beentaken by governments to minimize the use oftreaty networks to reduce taxes, for example,through treaty shopping.

Brazil's recently adopted worldwide taxsystem created the potential for a novel taxsavings opportunity for Brazilian companies.The critical tax authorities underlying thisopportunity include the following:

• Treaty Provisiono Brazil's standardand longstanding tax treaty with Portugal,including its territory of Madeira Island,indicates that Brazil may tax foreign incomeupon repatriation, but not accrued foreignincome" Madeira Island is a tax haven thatfalls in the no ar low tax category,

• The Law. As already noted, underBrazil's new worldwide tax system the incomeof foreign subsidiaries is taxed as accrued, notupon repatriation."

• Normative lnstruction (NI). It hasalso been noted that, about six months afterthe law was enacted, a tax pronouncement , orso-called NI, provided that authorities actcontrary to the law and tax foreign incomeupon repatriation, and not accrued foreignincome." Although taxpayers may act inaccordance with the NI, arguably ir does notsupercede the law. Therefore, a case can bemade for taxpayers to act at their discretionunder either the law or the NL

Consider a Brazilian corporation with aMadeira Island subsidiary. Two events arerelevant to the analysis, First, income isrecognized on Madeira Island through transferpricing or other mechanisms, Second, thisincome Is repatriated as a di vidend to theBrazilian parent. Exhibit 7 summarizes theinteraction among these events and theauthoritíes cited above,

Upon the first event, income recognitionon Madeira Island the treaty provision

26. Under agreement between theNetherlands and NetherlandsAntilles, the withholding rate may bebetween 5 and 7.5 percent.

27. 20% = 25% alternative 1withholding tax rate - 5% alternative2 withholding tax rate,

28. Tax treaty Article 7.

29. Law 9.249/95. Arliele 25.December 26, 1995 effective January1,1996.

30. Instrução Normativa 38. Article2, Sectlon 1. June 28, 1996.

51

CONCLUSION

31. At this writing, Brazil has taxtreaties with Argentina, Austria,Belgium, Canada, the People'sRepublic of China, Czechoslovakia,Denmark, Ecuador, Rnland, France,Germany, Hungary, India, Italy,Japan, Korea, Luxembourg, lheNetherlands, Norway, lhePhilippines,Portugal,Slovakia,Spain,and Sweden. Brazil is currentlynegotiating tax treaties with Chile,Romania, Switzerland, the UnitedKingdom, lhe United States, andVenezuela.

52

Exhibit 7Madeira Island Tax Haven Use by Brazilian Companies

fvenf ,: Income reco(ln;zeJ by'o,e;(I" subs;J;ary

(aiTreaty

(fax dividend)

(blNo

Treatyflle"t 2: DíllíJe"Jís poíJ (a)

Law(fax accruedearnings)

(ilno

Btazilion tax

(ii)immediate

Brazilian tox(with FTC)

(b)NI

(tax dividend)

(iii)defer

Brazílian tax(wífh FTC)

(i v)defer

Brazilian fax(wlth fTC)

(column a) dominates domestic law, bencetbere is no taxable income recognized byBrazil. In addition, the income is not taxedon Madeira Island because of its zero tax rate.When, in the second event, income isrepatriated to Brazil, the taxpayer minimizestaxes by choosing to act under the law (rowb) which stipulates that dividends are nottaxed. In short, the Brazilian parent escapestax altogether (cell i) under this strategy.

If a subsidiary is in a country that doesn 'tparticipate in the treaty (column b)31, tbeBrazilian parent minimizes income taxes bychoosing to operate under the NI (row b).Accordingly, Brazilian income taxes aredeferred (cell IV) until earnings arerepatriated. This is pr..clerable to operate-----under the law (row a) and immediatly beingtaxed in Brazil (cell ii) as foreign income isaccrued at home even if not repatriated.

At this writing, the argument is still openfor the Madeira Island strategy above, albeitstill subject to the success of potentialgovemment counter arguments. Nonetheless,this strategy is likely to be short lived becauseof its unintended outcome and transparentnature. When ir ceases to be available, theuse oftax havens by Brazilian companies willlikely conform more readily to the use adoptedby most other nations under a worldwide taxsystem. More specifically, to the extentBrazilian companies can recognize and retainincome in tax preferred countries they willdefer Brazilian income taxo However, uponrepatriation, this income will be subjected toBrazilian tax with the possible relief of the -foreign tax credit.

A worldwide tax system is of value to acountry only if its businesses have significantinternational operations. Accordingly, theadoption of such a system is an indication ofBrazil's increasing globalization and futureexpansion. At the same time, the fundamentalchange represented by this new systemintroduces a new levei of complexity thatcreates significant challenges for govemmentsand businesses alike. No longer do taxesapply to income just within Brazil's territoryas under the former territorial tax system.Now the interaction of tax systems and ratesacross multiple countries must be considered.The fundamental danger this creates is thepossibility of double taxation. The commonresponse adopted by Brazil and othergovernments is foreign tax credits and anetwork of bilateral treaties. The concept ofthose mechanisms is simple, but their

, . . . . . . . . . . . . . . . . . . . . . ,A worldwíde fax sysfem ís ofvolue to o country on/y if Itsbusinesses hove sígníficanfinfernatíonal operatíons.

Accordlng/~ lhe adoptíon ofsuch a sysfem ;$ an indicafíon

of Brazil's increosíngglobo/ization and Mure

expansion.'" ,. • • • • • • • • • • • • • • • • • • • • I

application may be fraught with difficulties.These difficulties impose adrninistrative costson governments and compliance costs 00

businesses. The Brazilian government intendto benefit from the experiences of othercountries with long-standing worldwidesystems. Similarly, Brazilian multinationalcompanies can look to the numerous strategiesand expertise already developed by non-Brazilian multinationals in their efforts tominimize global taxation. O

RAE • v.37 • n. 1 • Jan./Mar. 1997