The location of a business and structuring of a company’s activities to take advantage of low tax opportunities, with the aim of optimizing taxes, is called tax planning. It is both a tax reduction and tax avoidance mechanism. The objective of tax planning is to reduce (rather than minimize) a group’s tax burden and its effective tax rate.
MNCs use a variety of tax planning strategies to bring down the group’s tax burden, some of which are briefly described below:
Strategy # 1. Income Shifting:
It is a tax planning strategy in which income from high tax countries is shifted to low tax countries through transfer pricing of goods and intangibles. It can result in a steep loss of tax revenues for the high-tax country. Conversely, current tax payable is reduced by moving the amount of tax paid to future periods.
Strategy # 2. High Leverage:
Since interest is a tax-deductible expense, high leverage of an MNC affiliate in a high tax jurisdiction is a tax planning strategy. Intra-group loans are a tax planning strategy—an MNC affiliate in a tax haven gives a loan to an affiliate in a high tax jurisdiction and the parent MNC may borrow money and use this to ‘inject’ equity into the affiliate in the tax haven. It then makes this affiliate lend the money to an affiliate in a high-tax country. Such intercompany debt by tax haven affiliates is permitted by Japan.
Strategy # 3. Creation:
It is a tax planning strategy in which companies operating from a high-tax country relocate to a low-tax jurisdiction, so as to reduce the effective tax rate. Companies opt to change their primary establishment from one country to another so as to take advantage of the lower and more favourable tax regime.
Tax driven relocations can become disputes that require a court judgment. If a company located in a country that levies capital gains tax, shifts its primary establishment to another country that does not levy capital gains tax, the company becomes a non-resident and avoids capital gains tax.
Strategy # 4. Use of Tax Havens:
As a tax strategy, it is so widespread that MNC income earned from tax havens is out of proportion to the tax havens’ levels of economic activity. So rampant is this practice that given their small size (Mauritius, Netherlands Antilles, and the Cayman Islands), tax havens account for a significant share of the world’s FDI. Portfolio investment is routed into a country through a tax haven with which the tax haven has signed a double taxation avoidance agreement.
Mauritius is the preferred tax haven through which foreign portfolio investment comes into Indian capital markets. Mauritius has no withholding tax. The tax year is from July 1 to June 30. The domestic corporate tax rate applies to offshore entities, which is of two types. Global Business Company Category 1 is treated as a resident.
If it has a Tax Residency certificate, it enjoys the benefits of DTAAs signed by Mauritius with other countries. Global Business Company Category 2 is treated as a non-resident. It can have a minimum share capital of 1 share. It does not enjoy the benefits of Mauritius’ DTAAs. It need not file annual tax returns, and can maintain confidentiality through nominee Directors.
There are around 40 tax havens around the world. They are usually small, rich countries (often islands) with small populations, not many natural resources and good telecommunication links. The popular perception is that they are used by persons to stash wealth acquired through tax evasion. Because tax havens reduce tax revenues in high-tax countries, the OECD published a list of tax havens, and encouraged them to improve their information sharing with other countries.
Strategy # 5. Tax Deferral:
It is a tax planning strategy, under which an MNC affiliate does not repatriate the parent company’s share of income (dividend, or interest). As a result, the parent company avoids paying tax in its country, and the affiliate avoids paying withholding taxes in its country.
Illustration:
An MNC affiliate in India pays a dividend of Rs. 1,000,000 to the UK parent company. The withholding tax is 20%. Tax rate in the UK is 30%. Calculate the tax savings if dividend is not repatriated.
Solution:
Withholding tax paid by the affiliate = 20% of Rs. 1,000,000 = Rs. 200,000
Dividend payable less withholding tax = Rs. 1,000,000 – Rs. 200000 = Rs. 800,000
Tax on repatriated dividend paid by the parent company = 30% of Rs. 800,000 = Rs. 240,000
Total tax paid = Rs. 200,000 + Rs. 240,000 = Rs. 440,000. This is the tax saved if dividends are not repatriated by the Indian affiliate.
Strategy # 6. Shell Corporation:
Establishing a shell corporation overseas is a tax planning strategy. A shell corporation (also known as an international business corporation) has no independent assets or operations of its own, and has existence only on paper. Though it has its own bank account, and an address, it has very little capital (a nominal amount as low as $1).
It does not reveal its Board of Directors, and it is very difficult to establish the true owners, since the corporation’s shares are not listed or traded on any stock exchange. It is usually set up in a country with strong secrecy laws, and it is difficult to determine the origin of money received into its bank account. One shell corporation may own another shell corporation, which may own shares in a company operating in another country.
Such a string of shell corporations makes tracing of ownership extremely difficult. Though it is not illegal to set up a shell corporation, it is viewed with suspicion by tax authorities across the world, since it may be used as a mechanism to evade taxes. Enron, an American energy trading company that collapsed, set up hundreds of shell corporations overseas, and used them to hide the debt it had on its books.
Strategy # 7. Regulatory Arbitrage:
It is a tax planning strategy that exploits differences in regulations between countries. If two countries have different treatments of an overseas branch with a resultant difference in tax status, there is scope for tax reduction. The MNC may set up a branch overseas, which is regarded as an offshore unincorporated ‘branch’ according to its home country tax rules, but is considered as an offshore incorporated entity, in the host country.
Similarly, if two countries have divergent views on the tax status of hybrid securities, the MNC may issue hybrid financial instruments (with features of equity and of debt) that are purchased by the affiliate. The hybrid instruments are treated as equity by the tax authorities of the MNC’s parent country, but are treated as debt instruments by tax authorities of the affiliate’s country.
Strategy # 8. International Holding Company:
A holding company is an independent division, or a regional headquarters. Setting up an international holding company is a tax planning strategy. It is set up in a low tax jurisdiction and can save an MNC millions in taxes. A ‘pure’ holding company is one which has no operating activities or operating income. Its main purpose is to hold a ‘long-term interest’ in one or more independent companies. A Euro-holding company is a holding company set up in the EU by a US parent company, and liaises with EU subsidiaries of the US parent company.
Strategy # 9. Corporate Inversion:
It is a tax planning strategy in which there is an exchange of corporate identities. The corporate structure is inverted so that the subsidiary becomes the parent company, and the parent company becomes the subsidiary. This mechanism, called ‘expatriation’, is used by American companies that want to avoid paying tax in the USA on their foreign incomes. How does it occur? The worldwide approach of taxation is used in USA. The US parent company chooses a subsidiary in a country which uses the territorial approach to taxation.
This subsidiary is made a parent, and the parent US company becomes the subsidiary. How can this be accomplished? The parent US company may set up a foreign shell corporation in a tax haven such as the Cayman Islands. The shell company issues its shares to the shareholders of the parent company, in exchange for the shares of the parent company from these shareholders. Alternatively, the shell company issues its shares to the parent company in exchange for the parent company’s assets.
Strategy # 10. Conversion of Income:
It is a tax planning strategy, since not all sources of income are taxed at the same rate—the tax rate on dividend may be different from that on capital gains or interest income; withholding tax may be levied on dividend income but not on interest income.
To take advantage of these differences, a holding company may give a loan to a subsidiary, on which it gets interest income. It then pays this as dividends to the parent company. It has converted interest income into dividend income. It can also do the opposite—that is convert dividend income into interest income.