Sample Paper: “International Taxation”

Question 1

Is there such a concept as ‘International Taxation’ in the real world and what actually is ‘tax planning’?
The concept of international taxation exists in the real world and it has become very popular in the recent past. This is hugely due to the globalization of the world economy where economies all over the world are interconnected. This concept has become important because of the realization by world leaders that the millennium development goals can’t be achieved without coming up with international tax. It’s worth noting that international tax is a completely new concept because historically, taxes have been associated with individual states. However, this has changed due to economic globalization where multinational companies pay taxes to more than one government. Many governments normally limit the extent of their income tax in certain circumstances based on territory. More to this, governments also limit the scope of their taxation based on residency, territory or exclusionary system. Several governments have tried to alleviate the conflicting limitations of each of the above mentioned systems through coming up with a hybrid taxation system with two or more characteristics. Tax planning is the act of coming up with strategies aimed at lowering the amount of tax payable within a certain period. Tax planning is important for both individuals and business because it enables them minimize the taxes that they pay. There are three major ways through which one can reduce the amount of tax that they pay namely increasing deductions, reducing income and taking advantage of tax deductions. The tax planning undertaken by MNEs in China are more effective compared to those in Australia. The tax planning activities are consistent with the Hofstede and Gray models.

Question 2
What are the mechanisms used by countries to provide relief from double taxation?
Double taxation occurs when tax is levied by two different jurisdictions on the same income. In the United States, double taxation refers to the requirement that companies pay tax on their profits and the shareholders are also taxed on their dividends. In most instances, double taxation is mitigated through enactment of tax treaties between the concerned countries. There are two major mechanisms used by countries to provide relief from double taxation. The first method is to carry out a thorough assessment of the foreign income and give a credit foreign tax paid. The second method offer a full exemption for certain types of foreign earnings on which tax has already been paid. On top the above mentioned unilateral measures, there are other mechanisms used by countries to provide relief from double taxation namely double tax agreements. The double tax agreements are also known as tax conventions and they are agreements between governments which lower the ability of local Revenue Authorities to tax the income of non-residents.

Question 3
What is a tax treaty? What is one of the most important benefits provided by most tax treaties? What is treaty shopping?
According to Gravelle, a tax treaty is a bilateral agreement between two countries that is aimed at eliminating incidences of double taxation. Generally, tax treaties decide the amount of money that a country can tax on the earnings of the tax payer. Normally, tax treaties cover several types of taxes like value added tax, inheritance tax and income tax. The countries that do not enter into this type of agreements are known as tax heavens. Tax teats have a lot of benefits to both the tax payer and the country involved. Among all the benefits, the most important benefit of tax treaties is reducing the chances of double taxation. This is done through ensuring that earnings that have been taxed in one country are not taxed in the other. It’s a well known fact all the world that the major purpose of any business is to make. This means that businesses must do everything in their power to increase their earnings or profitability. One of the main ways through which a company can ensure it remains profitable is to set up branches in countries with favorable laws. Consequently, treaty shopping is the practice of multinational companies to look for countries with favorable tax treaties. For example, a business based in a country that does not have a tax treaty with another country where it has branches, may opt to move its operations to another country with tax treaties with its mother country.

Question 4
What is transfer pricing and how do national governments deal with profit shifting? In your answer explain the concept of the ‘arm’s length principle’
Transfer pricing is the act of setting prices either services or goods between two companies that are related with one another. For parties in transfer pricing to be considered related, they must control one another or are either directly or indirectly controlled by a common party. An example or related entities in transfer pricing is a company’s head office and its outlets. In itself, transfer pricing is not illegal but it becomes illegal if there is manipulation of prices. One major through which governments ensure that prices in transfer pricing are not manipulated is through the application of the arm’s length principle. According to this principle, a market price is achieved when two unrelated companies trade with one another. The arms length principle is very popular is mainly used for the purposes of tax. When two related companies trade with one another, there is a risk that they may manipulate the prices at which they traded with an aim of reducing their tax bill. For example, a company may record huge profits in a tax heaven due to low taxes. National governments deal with profit shifting coming up with strict rules to govern transfer pricing.

Question 5

  1. Identify three tax havens discussed in the report and discuss three major methods of corporate tax avoidance outlined in the Report and briefly explain the size or magnitude of the tax avoidance problem. The three tax heavens discussed in the report are Bahamas, U.S Virgin islands and Costa Rica. The first major way through which companies avoids tax is through allocation of debt and earnings and stripping. In this method, companies move profits from a country with a high tax jurisdiction to one with a low jurisdiction. More to this, companies may borrow a lot of money in a country with high tax jurisdiction compared to the one with low jurisdiction. The second way through which a company can avoid taxes is through transfer pricing. This is the act of setting prices of either services or goods between two companies that are related with one another. This is done by reducing the prices of goods sold by a company in countries with low tax jurisdiction and increasing the prices of purchases therefore shifting the income. The third was that companies use to avoid tax is through contract manufacturing. This occurs when a company sets up a subsidiary in a country with low tax. The tax avoidance is very serious throughout the world and governments are losing a lot of money. It’s estimated that the United States government lost over $60 in tax evasion.
  2. Formula Apportionment- according to this method, profits would be assigned to diverse jurisdictions on the basis of their shares of assets, sales and employment.
    Broad Changes to International Tax Rules -This policy requires that changes be made to the international tax regulations to ensure that companies stop profit shifting. The main area that the above mentioned changes should focus is on deferral and allocation of both capital and income.
  3. I believe that the above mentioned measures will be very successful in reducing cases of international taxation issues identified in the report.

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