International tax planning necessary to reduce incidence of taxation

Roy Rohatgi

International tax planning is the art of structuring the proper combination of transactions and the ownership of entities lawfully to ensure tax effective routing of business activities and capital flows on cross-border transactions.

It is based on the use of bilateral tax treaties and domestic tax laws using international offshore financial centres, where appropriate. International tax planning helps to reduce the distortions in internationally organised business that are produced by the lack of harmonisation in international tax arrangements.

The tax planning strategies deal with how to optimise after-tax income and capital flows (and not just minimise the tax liability), after considering transaction costs, the management structure and business risks. The prime objective is to receive the after-tax flow of overseas incomes at least costs and risks, consistent with the overall business objectives.

Corporate income may be either active business income or passive income, such as dividends, interest, royalties, management fees, rental payments and capital gains. Individuals may be subject to foreign tax on their employment or professional incomes, director’s fees, pensions and other services overseas.

International tax planning combines these cross-border transactions in the most tax efficient structure through the knowledge of international taxation.

The best tax planning does not necessarily result in the lowest fiscal burden in absolute terms. However, it helps to lawfully reduce the cumulative incidence of taxation to a minimum as compared to the countries through which the transaction flows.

Its purpose is to eliminate, minimise or defer the imposition of the tax burden on taxable persons and events lawfully in the attainment of the desired business and other objectives.

The planning process examines the likelihood of juridical and economic double taxation, and the possible advantages that could be gained from the interrelationship of two or more tax systems. Foreign source income received may be tax exempt, or taxable only partly in the Home country. It may be possible to achieve nil tax if the person can be deemed non-resident in both the Home and Host countries; alternatively, improper planning can lead to taxation in both countries.

A. Need for international tax planning
The cross-border investment decisions and global business transactions are made on commercial considerations of business viability, market access and market potential. Other persuasive factors include political and economic stability, government grants and incentives, geographical location, business infrastructure, availability of skilled and low cost work force, strong currency, etc.
Tax is not usually a primary or overriding factor in global investment decisions. They are (and should be) rightfully based on sound commercial, economic and sometimes even on social and political considerations.

Once the initial investment decision is made, taxes become an important business consideration as the single most significant expense. International tax issues affect the ultimate return on the investments and influence the long-term financial feasibility of business decisions. Business entities must plan to control their global tax expenses. Without international tax planning, multinationals would suffer “tax waste” or excess tax payments in various jurisdictions.

The right to tax is one of the sovereign rights of each country. Most countries tax their residents (or citizens) on their worldwide income. However, countries where the incomes are sourced also exercise their legitimate right to tax the same income. These taxing rights often lead to double or multiple taxation on the same income. As a result, cross-border activities usually suffer a higher tax liability on a worldwide basis than just domestic or one-country transactions.

Domestic tax planning is concerned primarily with the country’s rules of tax deductions (whether immediate or deferred), allowances and exemptions, and the difference in the tax rates on various sources of income. Tax deductions, usually, do not affect the total tax revenues of the country since they form a taxable income of another domestic entity.

International tax planning involves similar factors, but it also impacts the sharing of tax revenues among countries. There are also additional tax considerations, such as tax incentives and exemptions for foreign incomes, tax treatment of exchange gains and losses, availability of foreign tax credits, etc. It also permits the use of third countries as intermediaries for tax purposes.

The Business and Industry Advisory Committee of the OECD described the need for international tax planning as:

“The minimisation of costs and taxes due is a legitimate concern of each business; much of the use of tax havens is not motivated by a desire to pay little or no tax, so much as an economic necessity to reduce costs, including taxes, to a bearable level in circumstances where the laws of countries are uncoordinated and even the laws of individual countries are inconsistent, insofar as they relate to the treatment of international business.”

B. Opportunities for international tax planning
Opportunities for international tax planning are limitless. They can arise from a variety of tax factors. For example, the scope of taxation may differ from the Home country, due to varying residence and source rules, and tax treatment of foreign earnings may vary.

The distinction between capital and revenue income and expenses, and the tax classification of revenue items, may differ. Furthermore, differing tax treatment and rates of tax may apply to various legal persons and categories of revenue or capital.

The extent of the tax benefit from planning again depends on several factors. They include the amount of income earned abroad, the difference between domestic and foreign tax rates, and in case of tax deferral, the period of deferral and prevailing interest rates.

International tax planning may not be of much use if the overseas operations are loss-making, unless the losses are deductible at Home. In addition, countries usually limit tax credits to Home tax on equivalent income. Therefore, if foreign taxes are higher, tax planning should aim at reducing them to creditable levels at Home, i.e. the State of residence.

The author is ex-managing partner, Arthur Andersen, India. The
views expressed here are his own.