Double Tax Jeopardy Implications for Multi-National Companies from an Accountant’s Point of View

As a result of entering the global economy and reaping the financial rewards, more U.S. multi-national companies (MNC) and their expatriates are finding themselves in a position where tax liabilities may be owed to two or more national jurisdictions based on foreign income earned. The issue of double tax jeopardy has caused officers of such organizations to consider the means whereby they can minimize overall tax liability accruing from all their global activities, their organizations, and their employees. Being American firms - often repatriating or directing funds to and from the United States - they usually look to the United States as the part of their global operations where they would be most familiar with tax consequences, thus seeking to minimize tax in the U.S.

The purpose of this paper is to examine the risks associated with using certain tax minimizing strategies in an effort to avoid double tax jeopardy. This paper first defines and discusses the issue of double tax jeopardy as it currently applies to U.S. employees working overseas and their US based employers. Next, the paper discusses how U.S. firms and their expatriate employees currently avoid double tax jeopardy, followed by a discussion on whether the techniques employed can be justified and/or are ethical. Also the risks associated with avoiding double tax jeopardy are identified, and implications of using tax minimizing techniques are discussed.

What is double tax jeopardy?

Double tax jeopardy is an issue that stems from the concept of double taxation, wherein income is taxed twice (Turnier, 2007; Wilkinson & Fancher, 2004). Double taxation can occur when:

The same tax authority taxes multiple entities’ income and/or assets (Wilkinson & Fancher, 2004; Encyclopedia of Small Business, 2002).

Multiple tax authorities tax the same entity’s income and/or assets (Reuven, 2005).

Income and/or assets can be taxed by the same tax authority, as evidenced with treatment of corporate dividends (Wilkinson & Fancher, 2004). Corporate dividends are paid out from retained earnings, an account which represents the cumulative impact of net incomes and losses since the entity’s inception (Horngren, Harrison & Bamber, 2005). Internal Revenue Service (IRS) regulations reflect the same principle, and common stock dividends cannot be paid unless a sufficient balance in the retained earnings account to cover payment exists (Horngren, Harrison & Bamber, 2005), indicating that dividends can only be declared on income that was previously or is currently being taxed. Also according to IRS regulations, corporate dividends are recognized as taxable income by the entity receiving the payment (Internal Revenue Service, 2008 [Instructions for Form 1120 U.S. corporate income tax return]; Internal Revenue Service, 2008 [1040 instructions 2007]; Internal Revenue Service, 2008 [2007 Publication 17]); however, the corporation neither receives a deduction for common stock dividends declared nor issued (Wilkinson & Fancher, 2004). Since the money that dividends are paid out from taxed income (Wilkinson & Fancher, 2004) is subject to tax again by entities receiving the dividend money, double taxation occurs.

An individual entity can be subject to double taxation by having income and/or assets taxed by multiple tax authorities. U.S. companies and individuals can be subject to double taxation simply by being located in a state that taxes income. On the corporate level double taxation is inevitable when a company is located in a state that charges a corporate income tax, since the IRS does not allow a deduction for taxes based on income taxes paid to a state or local tax authority (Internal Revenue Service, 2008 [Instructions for Form 1120 U.S. corporate income tax return]). On the individual level, however, double taxation can be avoided when the taxpayer(s) can use state and local taxes paid as an itemized deduction on Schedule A (Internal Revenue Service, 2008 [1040 instructions 2007]; Internal Revenue Service, 2008 [2007 Publication 17]) and in instances where the taxpayer(s) income falls within specific income guidelines to take advantage of state tax relief programs, if such provisions exist. An example of such a program is Pennsylvania Tax Forgiveness, where resident taxpayers can apply for a credit up to 100% of the state tax liability (Pennsylvania Department of Revenue, 2008).

Double taxation can occur in similar manners for U.S. entities involved in international commerce, although the more common method of double taxation stems from the situation where assets and/or income are subject to taxation under U.S. and foreign tax regulations. While Congress has taken steps in reducing the tax burden for U.S. MNCs, the IRS admits that a tax gap still exists (Internal Revenue Service, 2008 [The tax gap and international taxpayers].

Methods of minimizing international tax liabilities

U.S. entities involved in international commerce have several options to avoid international double taxation. Bilateral tax treaties are a common form of relief (Beck, 2002). U.S. entities can also shift their operations, assets or earnings abroad, which the current U.S. tax structure is trying to avoid (Graetz & Oosterhuis, 2001). A third option is to partake in tax arbitrage.

Bilateral tax treaties

According to Beck (2002):

“Most [tax treaties] are based on one of three models--the United States Model Income Tax Convention of September 20, 1996 (the U.S. Model), the United Nations Model Double Taxation Convention Between Developed and Developing Countries (the U.N. Model) or the Organization for Economic Cooperation and Development (OECD) Model Tax Convention on Income”(par. 1).

Under common international practices, the host country taxes the entity, while the home country provides the tax relief. In order to qualify for tax relief, the entity must meet residence and/or citizenship requirements (Beck, 2002). “No international consensus dictates the appropriate relief method; countries commonly use three--the deduction method, the exemption method and the credit method. Countries can use one method or a combination to provide relief from international double taxation” (Beck, 2002, par. 2).

“The deduction method (such as the U.S., under Sec. 164(a)(3)) allows residents/citizens to deduct foreign taxes paid in computing their taxable worldwide income. This treats the foreign taxes paid as a current expense; it is the least effective means of providing relief. Residents paying and deducting foreign taxes on foreign-source income are taxed at a higher combined rate than on domestic-source income.” (Beck, 2002, par. 3).

“Under the exemption method, a taxpayer's home country will tax its residents/citizens only on their domestic-source income. The country of residence exempts the taxpayer's foreign-source income from domestic taxation, leaving it to be taxed by the source country” (Beck, 2002, par. 4). The credit method provides relief by offering the entity a credit against the home country’s tax liability in an amount equal to the tax liability assessed or paid on foreign income. The credit taken cannot exceed the home country’s tax liability.

Shifting operations, assets, or earnings abroad

Existing U.S. laws dictate that domestic corporations are considered residents of the U.S. and that, if the organization has branches overseas, then the income earned in the other country(ies) is subject to the U.S. corporate tax as well as foreign income tax (Graetz & Oosterhuis, 2001). To avoid double taxation, the corporation can open a foreign subsidiary (i.e., a separate entity) which is not subject to taxes in the U.S., provided the subsidiary earns no income in the U.S. (Graetz & Oosterhuis, 2001). The earnings of the foreign subsidiaries are only subject to U.S. taxation when distributed to their U.S. owners in the form of dividends (Graetz & Oosterhuis, 2001).

International arbitrage

International arbitrage is known as “the exploitation of differences between or within national tax codes” (Haworth & Buchanan, 2005). In other words,

“international tax arbitrage arises when a taxpayer or taxpayers rely on differences between the tax rules of two countries to structure a transaction, entity or arrangement in a manner that produces overall tax benefits that are greater than what would arise if the transaction, entity or arrangement had been subject only to the tax rules of a single country (Reich, 2007, par. 1)”

Arbitrage can be obtained improperly via “incorrect or improper application of the tax laws of any country, transactions in which the taxpayers take inconsistent factual positions in their respective countries and other cases that are more appropriately viewed as abusive tax shelters” (Reich, 2007, par. 2). Below are a few examples of how a U.S. MNC can legitimately take advantage of international arbitrage:

“[S]eparate the foreign tax credit from the tax base to which it relates, so that the taxpayer can benefit from the credit without having to include the related income” (Reich, 2007, par. 10).

“[Taking advantage of] transactions that permit the effective duplication of tax benefits in two countries, usually because the United States treats the U.S. participant as the owner of the entity that pays the foreign income (or withholding) tax and allows it a foreign tax credit while a foreign country treats the nonU.S. participant as owning all or a substantial portion of the entity for purposes of its tax law” (Reich, 2007, par. 17). This is known as double dipping (Haworth & Buchanan, 2005).

Exploiting reverse foreign tax credit transactions, wherein “the non-U.S. participant claims the U.S. tax as a foreign tax credit in its home country, while the U.S. participant receives its share of the investment entity's profits without additional U.S. tax, as a result of the 100-percent dividends received deduction or filing a consolidated return with the investment entity” (Reich, 2007, par. 29).

Claiming U.S. withholdings tax paid “as a credit by both the U.S. participant and the foreign participant in their respective countries” (Reich, 2007, par. 33).

Justification of tax minimizing strategies

There is a fine line between using the tax law to one’s advantage and illegally abusing the tax laws. Tax avoidance is defined as “[t]he use of legal methods to modify an individual's financial situation in order to lower the amount of income tax owed” (Forbes, 2008). Tax evasion, however, is “[a]n illegal practice where a person, organization or corporation intentionally avoids paying his/her/its true tax liability” (Forbes, 2008). Provided that the entities that operate in the global economy did not violate any laws, the use of tax minimization strategies is not illegal, including taking advantage of bilateral tax treaties; shifting operations, assets, or earnings abroad; and/or international arbitrage. For example, timing dividend distributions from a controlled foreign subsidiary to take advantage of the U.S. foreign tax credit (Reich, 2007) is legal.

Organizations and individuals must be careful to stay abreast of changes in tax laws to avoid being in a situation where the entity is not complying with tax laws (Bauman & Mantzke, 2004), as even inadvertent violations are deemed to be methods of tax evasion (Corley, Reed, Shedd, et al, 2002). For example, the U.K. proposed anti-arbitrage rules in an effort to prevent double dipping and to protect its tax base in 2005 (Haworth & Buchanan, 2005). Also important to note is the fact that the IRS provides information on what the U.S. government considers abusive international tax schemes and tax shelters. Staying abreast of potential regulations will help a company stay legal.

Even if an entity is following all applicable laws, the individual or corporation may not necessarily be acting in an ethical manner – at least according to U.S. standards. For example, the presence of tax treaties may entice domestic companies to conduct business overseas while preventing the transfer of assets, operations, or income overseas from occurring (Graetz & Oosterhuis, 2001), the treaties allow U.S. corporations to participate in international arbitrage (Haworth & Buchanan, 2005). While international arbitrage is legal, it is not equitable, as it takes advantage of another country’s tax laws for the sake of profit – forcing one country to forsake its tax base. Also, if a company decides to transfer its operations, assets, and income to a foreign subsidiary it costs U.S. employees jobs.

The biggest risks in minimizing international tax liability are not ethics related; rather they are related to the failure to keep up with tax laws in the countries that the entity does business in. Failure to comply with tax regulations – whether home country or host country – can result in fines, penalties and/or imprisonment. The bottom line: consult a tax professional familiar with international tax laws.

References

Bauman, C. C. & Mantzke, K. L. (2004). An education and enforcement approach to dealing with unscrupulous tax preparers. Journal of Legal tax Research, 2. Retrieved October 11, 2006 from Business Source Complete.

Beck, A. M. (October, 2002). Relief from international double taxation. The tax Adviser, 33(10). Retrieved June 5, 2008 from the Gale Power Search database.

Corley, R. N., Reed, O. L., Shedd, P. J. & Morehead, J. W. (2002). The Legal and Regulatory Environment of Business, 11th Ed. McGraw-Hill: New York

Encyclopedia of Small Business, 2nd Ed. (2002). Hillstrom & Hillstrom. Retrieved June 5, 2008 from the Gale Power Search database.

Forbes (2008). Tax avoidance. Investopedia. Retrieved June 5, 2008 from http://

www.investopedia.com/terms/t/tax_avoidance.asp

Forbes (2008). Tax evasion. Investopedia. Retrieved June 5, 2008 from http://

www.investopedia.com/terms/t/taxevasion.asp

Graetz, M. J. & Oosterhuis, P. W. (December, 2001). Structuring an exemption system for foreign income of U.S. corporations. National Tax Journal, 54 (4). Retrieved June 5, 2008 from the Gale Power Search database.

Haworth, D. & Buchanan, H. (May, 2005). Clamping down on international arbitrage. International Tax Review. Retrieved June 5, 2008 from the ProQuest database.

Horngren, C. T., Harrison, W. T., & Bamber, L. S. (2005). Accounting, 6th Ed. Pearson Education: Upper Saddle River, NJ.

Internal Revenue Service (2008). Instructions for Form 1120 U.S. corporate income tax return. Retrieved June 5, 2008 from http://www.irs.gov/pub/irs-pdf/i1120.pdf.

Internal Revenue Service (2008). 1040 instructions 2007. Retrieved June 5, 2008 from http://www.irs.gov/pub/irs-pdf/i1040.pdf.

Internal Revenue Service (February, 2008). The tax gap and international taxpayers. Retrieved June 5, 2008 from http://www.irs.gov/businesses/article/

0,,id=180215,00.html.

Internal Revenue Service (2008). 2007 Publication 17: your federal income tax for individuals. Retrieved June 5, 2008 from http://www.irs.gov/pub/irs-pdf/p17.pdf.

Pennsylvania Department of Revenue (2008). PA personal income tax guide. Retrieved June 5, 2008 from http://www.revenue.state.pa.us/revenue/lib/revenue/

pitguide_chapter_20.pdf.

Reich, Y. Z. (March, 2007). International arbitrage: transactions involving creditable taxes. Taxes, 85 (3). Retrieved June 5, 2008 from the ProQuest database.

Reuven, S. A. (Fall, 2005). All of a piece throughout: the four ages of U.S. international taxation. Virginia Tax Review, 25(2). Retrieved June 5, 2008 from the Gale Power Search database.

Turnier, W. J. (Summer, 2007). Theory meets reality: the case of the double tax on material capital. Virginia Tax Review, 27(1). Retrieved June 5, 2008 from the Gale Power Search database.

Wilkinson, B. & Fancher, M. M. (August, 2004). Eliminating ‘double taxation’: the dividend imputation alternative. (tax policy analysis)(Jobs and Growth Tax Relief Reconciliation Act 2003). The CPA Journal, 74 (8). Retrieved June 5, 2008 from the Gale Power Search database.