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Smeal College of Business Taxation and Management Decisions: ACCTG 550Pennsylvania State University Professor HuddartSystems of Taxation1In thinking about the taxation of activities that span national borders,it is necessary to consider multiple levels of taxation that apply as a dollarof profit makes its way from the foreign enterprise to a domestic enterprise,and finally into the hands of individual shareholders. This note classifiestaxation schemes around the world according to the manner in which profitsand dividends are taxed en route to shareholders.1. Classification of International Tax RegimesThe taxation of profits earned abroad is handled in several distinct ways.At the most abstract level, the total tax paid depends on whether the homecountry adopts a worldwide or territorial perspective and whether and howthe home country computes a dividend tax credit for individual shareholderswho receive dividends from domestic corporations. Countries can be broadlyclassified on these two criteria as shown in the table below.Territorial WorldwideFull Imputation France United KingdomGermanyPartial imputation Canada JapanNo Imputation United StatesThe taxation of a foreign subsidiary’s earnings by the country in whichthe subsidiary’s parent is located depends upon (i) whether the home countryadopts a territorial or worldwide system of taxation, and (ii) the nature ofthe imputation regime that applies on corporate distributions to individualshareholders. Under a territorial system, the repatriation is not taxed by1This material is drawn principally from Jennifer Babcock (1996)“The Impact ofImputation Systems of Taxation on Cross Jurisdictional Income Shifting,” Working paper,Duke University; and, Richard Sansing (1996) “Foreign investment decisions in thepresence of real options,” Working paper, Yale School of Organization and Management.cSteven Huddart, 1995–2005. All rights reserved. www.smeal.psu.edu/faculty/huddartACCTG 550 Multinational TaxHome countryForeign countryParent Corp.Foreign Subsidiary Corp.ShareholderFigure 1. The simplest multinational corporate structure. In thisstructure, a domestic parent corporation holds all the equity offoreign subsidiary. In turn, the parent is owned by a shareholderwho is subject to tax only in the home country.the home country. Under a worldwide system, the repatriation is taxed;however, this tax is mitigated by allowing a tax credit for foreign taxes paid.Subsequent distributions to shareholders of foreign earnings may or may notgive rise to a dividend tax credit.Page 2Multinational Tax ACCTG 550The foregoing presumes taxable income is allocated among jurisdictionsaccording to the arm’s length method, which is sometimes called the separateaccounting method. Under separate accounting, the related corporationsof a multijurisdictional enterprise are viewed as distinct from one another;taxable income is determined separately for each individual corporation bythe jurisdiction in which that corporation actually conducts business orhas a permanent establishment. Any improper shifting of value betweenthe related corporations to avoid taxes is corrected by requiring “arm’slength” pricing in related corporate transactions. In other words, the relatedcorporations must act as if they were unrelated entities dealing at arm’slength in the market-place. Of course, “arm’s length” pricing is difficult todetermine unambiguously for many goods and services because well-definedmarkets do not exist for them. This means there is scope for businessesto reduces tax payments by adjusting transfer prices to shift income tojurisdictions where the income will be lightly taxed.In addition to allocating taxable income among nations, taxable incomealso must be allocated across sub-national jurisdictions, such as the fifty stateof the United States, because some states levy income taxes—sometimescalled franchise taxes. In the US and other countries, allocation of income forsub-national income tax purposes is accomplished using a method called for-mula apportionment. Sometimes this method is called the unitary businessmethod. Under this method, the total income for the national jurisdictionis allocated across the sub-national jurisdictions according to a formula thatcommonly depends on the amount of sales, payroll expense, and propertyin each sub-national jurisdiction. Under formula apportionment, the relatedcorporations of a multijurisdictional enterprise are viewed as a single entity.One sub-national jurisdiction, the State of California, seeks to apply theincome tax it levies using the unitary apportionment method applied to theworldwide income of the subject corporation. California does this in partbecause it fears revenue leakage due to the transfer pricing manipulationsthat occur under the arm’s length method of income determination. Whilethe US Federal Government uses the arm’s length method, and is also worriedabout revenue leakage, it opposes California’s use of the so-called worldwideunitary method on constitutional grounds. For an interesting introductionto this complex issues, see the appendix to this note.2. Multilateral perspective in international taxationThere are several places where income potentially is taxed on its routePage 3ACCTG 550 Multinational Taxfrom the corporation where it was earned to the individual shareholder:• Taxation of income in the foreign corporation– The earnings of a foreign subsidiary are taxed by the country wherethe subsidiary operates.• Taxation of dividends paid from foreign subsidiaries to a domestic parentcorporation– Often, a withholding tax at a rate of either 10% or 15% is payableto the foreign taxing authority on distribution of a dividend to aperson who does not reside in that foreign jurisdiction. Note thatthis tax is levied by the government of the jurisdiction in which theforeign firm is located.– Territorial system. When the parent company is located in countrythat uses the territorial system of taxation, no tax is due tothe home country when earnings are repatriated in the form ofdividends.– Worldwide system. When the parent company is located in countrythat uses the worldwide system of taxation, more tax may dueto the home country when earnings are repatriated in the formof dividends. However, this tax is mitigated by a tax credit forforeign taxes paid. Roughly speaking, the home jurisdiction taxesthe foreign pre-tax income of the subsidiary that gave


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