International Econ: Class 9 + 11 + 12

Question 1

What is the most important tax in the international setting?

Answer 1

Corporate tax is the most significant, most complex and potentially most distortionary in the international setting

Question 2

Fundamental International Tax Principle # 1

re: taxation of trade, exports especially

Answer 2

Regarding Trade, nations do not want to tax their exports
-Why? They would shoot themselves in the foot
-Any tax you put on an exported good will reduce the competitiveness of your good in the international market, so anything you do to impose a domestic tax on exported goods will hinder your competitiveness
Exceptions:
-Policy makers could impose a tax on an export to your nations advantage if and only if your nation has market power with respect to that good. So you can push up the price and not dramatically reduce the output, and you can capture more revenue. Examples: Uranium in Canada (we are a major producer), and Oil

Question 3

Fundamental International Tax Principle # 2

re: taxation of foreign firms by a “host” country

Answer 3

Regarding Foreign Investment, most nations extend “national treatment”

• National treatment is a nation’s commitment to treat all firms operating within its jurisdiction identically for tax purposes
• Canada (and other countries) is host to a lot of foreign firms, so when you tax corporations, you will tax foreigners the same as you tax your own people
• There was one exception (that doesn’t exist anymore) – in China they taxed their foreigners differently than domestic firms. They did this so that more foreigners would come in, and bring new technology, networks and other features

Question 4

Fundamental International Tax Principle # 3

re:”capital export neutrality”

Answer 4

Regarding Foreign Investment, most nations try to avoid creating any “tax preference” for outward forward direct investment

• Capital export neutrality is tax neutrality between domestic and foreign investment
• You don’t want your tax system giving encouragement or discouragement to foreign investors to your country, so it has to be neutral

Question 5

Fundamental International Tax Principle # 4

re: protecting the home tax base

Answer 5

A nation will defend the integrity of its tax system against “revenue leakage” or abuse via international tax arbitrage or evasion

• Key words: international tax arbitrage, transfer pricing, thin capitalization, harmful tax competition, tax havens
• There are limits – there is only so much your administration can do
• You want to build a system that minimizes the chances of this kind of evasion

Question 6

Fundamental types of taxes (3)

Answer 6

1. Taxes on “factor incomes”
   - Factor incomes such as corporate income tax, which is a tax on capital income.
   - These are called direct taxes
   - There are 2 kinds of factors: labour and capital, and these factors generate income. So any tax on them (like a corporate tax) is a direct tax because it directly taxes the factor
2. Taxes on “value added”
   - This is the most important tax in the international dimension. It’s neither direct or indirect.
3. Sales and excise taxes
   - These are trivial in an international setting and are not our concern
   - Every time you buy a bottle of wine these have excise taxes, a tax that the government imposes on each individual good

Question 7

Source vs Residence Country

Answer 7

Source Country – where the income from the FDI is earned. Sometimes called the host country
Residence Country – the country from where the capital (FDI) comes. Sometimes called the home country.
Example: if Microsoft (US) generates income in Canada, Canada is the source country but the residence country is the US.

Question 8

US Approach to Taxing the Income of US-based multinationals

Answer 8

• All corporate income of US-based multinationals, regardless of where in the world it is earned, is subject to US tax, assessed according to the US rules
• The US gives tax credit, “the foreign tax credit” for foreign taxes paid
• US tax liability kicks in only on repatriation (the “deferral provision”)
• Companies who know they will have to pay tax when they send money back to the US may keep the money in the foreign country or send it to a tax haven country (Bahamas, etc) to hold the money
• Example #1: US tax rate higher than foreign tax rate
  
  • US firm sets up operations in Australia
  • US tax rate is 35%, Australian tax rate is 20%
  • Say $100 foreign income, therefore foreign tax = $20 and US tax = $35
  • When the funds come back to the US, the US will give a dollar for dollar tax credit for the $20 foreign tax paid in Australia, and then the firm will have to pay the difference of $15 (this is the US residual tax liability)
• Example #2: US tax rate lower than foreign tax rate
  
  • If the US tax rate is 35% and the foreign tax rate is 40%
  • On $100 foreign income, the US firm will pay $40 foreign tax
  • Since $40 is more than the $35 US tax, when the money comes back to the US they do not have to pay anything to US authorities
  • In these cases, firms could take their money back into the US without paying residual tax

Question 9

Canadian Approach to Taxing income of Canadian-based Multinationals

Answer 9

• Canada does not tax the active foreign-source income of Canadian based multinationals
• Why? Because of Administrative capacity – how can Canadians monitor the incomes of Canadian companies in the US? So they don’t worry about it. This is the exemption system
• Foreign countries tax at similar rates than Canadians would tax anyway, so Canadians don’t bother taxing their companies for small differences in tax
• Active income = corporate income from off-shore business operations. This is in contrast to passive or property income such as portfolio investment or real estate

Question 10

Value Added Tax

Answer 10

• Value added tax is the tax on the value added to a product
• VAT is unambiguously, explicitly and specifically tied to the value-added of specific products
• If a product is exported, then VAT is rebated in a boarder tax adjustment
• The VAT rebate on exports does not compromise a nation’s corporate tax

Question 11

EU vs US VAT Conflict 1991-2002

Answer 11

• US has no VAT, and the EU does
• So, the US thought that rebate of their corporate tax on exports would be like the EU rebate of the EU-VAT on EU exports
• The US tried various means to “rebate” the US corporate tax on US exports, but corporate tax rebates are WTO-illegal
• Corporate tax rebates are WTO-illegal because there is no way to specifically tie corporate tax to value added for a specific product (they include salaries, depreciation, etc and other factors that are not tied to a specific product)

Question 12

DISC

Answer 12

Domestic International Sales Corporation (DISC)

• Created by Congress in 1971 to level the playing field for US companies selling their products overseas
• A US exporting company would establish a DISC, which was a corporate entity owned by an American company (but the DISC was set up outside the US)
• DISC provisions permitted all US tax on the income earned by the DISC to be deferred until the DISC repatriated the income to its shareholders in the form of dividends
• For companies who did not pay dividends, this system allowed for an indefinite deferral of US tax on a portion of the income from foreign sales
• DISC provisions were challenged by the EU as providing an export subsidy that allowed an indefinite deferral of corporate tax on US exporters without an interest charge – which violated the terms of the General Agreement on Tariffs and Trade (GATT) (the precursor to the WTO)
• Revised the DISC and enacted the Foreign Sales Corporation (FSC)

Question 13

FSC

Answer 13

Foreign Sales Corporation (FSC)

• Enacted in 1984 as a revision of the DISC
• Provided US exporters with an exception from US tax for a portion of the income earned from export transactions
• Intended to provide them with tax treatment that was more comparable to exporters tax treatment in other countries (especially those who had VAT system)
• Allowed option of an interest charge DISC (IC-DISC), which permitted tax deferral to an annual max of $10 mil of export receipts, but at the cost of an annual interest charge
• Nov 1997 the EU formally challenged the FSC provisions in the WTO, stating that the FSC tax exemption was a prohibited export subsidy
• Oct 1999 the WTO panel issues a report finding that the FSC provisions constituted a violation of WTO rules

Question 14

ETI

Answer 14

FSC Repeal and Extraterritorial Income Exclusion Act (ETI)

• Enacted on November 15, 2000
• Legislation repealed the FSC provisions and adopted the ETI provisions
• Intended to bring the US into compliance with the WTO
• EU challenged it in the WTO, and in Aug 2001 WTO panel issued a report finding that the ETI provisions also violated the WTO rules
• EU was authorized to impose countervailing duties against the US in the amount of $4.2 billion in trade. Countervailing duties came into effect in 2004

Question 15

Fundamental International Tax principles (3)

Answer 15

1. Regarding Trade, nations do not want to tax their exports
2. Regarding Foreign Investment, most nations extend “national treatment”
3. Regarding Foreign Investment, most nations try to avoid creating any “tax preference” for outward forward direct investment
4. A nation will defend the integrity of its tax system against “revenue leakage” or abuse via international tax arbitrage or evasion

Question 16

GAAR

Answer 16

GAAR (General Anti-Avoidance Rule)

• Enacted in 1988
• When a taxpayer realizes a tax benefit from a transaction (or series of transactions), the tax benefit may be disallowed if:
  
  • The transaction is an “avoidance transaction” – in that it was not arranged primarily for bona fide purposes other than to obtain the tax benefit
  • The tax benefit constitutes “abusive tax avoidance” – in that it is not consistent with the object, spirit or purpose of the provision of the Income Tax Act relied on by the taxpayer to obtain the benefit

Question 17

Why do we have corporate tax? (4)

Answer 17

1. As a “benefits” tax – insofar as the public sector provides useful beneficial services to the corporate sector that are not otherwise built into the corporate cost structure (ex infrastructure, services, etc). Such benefits ought to be truly specific to recipient business (as opposed to pure “public goods”)
2. As a “withholding” mechanism to get at capital income. Without a corporate tax, there would be incentive to generate and retain income in corporate form (as opposed to personal income).
3. Corporate income is virtually the only way to tax the income of capital owned by foreigners (ex foreign subsidiaries).
4. Corporate tax is a mechanism to tax “economic rents”

Question 18

(12) Competition Policy Issues in 3 words

Answer 18

• Structure of the industry: degree of competition, and the degree of concentration in the industry
• Behaviour/Conduct of the firms: pricing, level of output, etc
• Efficiency (in terms of performance): whether or not goods and services are being delivered at a final price that reflects their costs. The smaller the gap between costs and sales price, then the more efficient it is

Question 19

(12) • The First Principle of Welfare Economics

Answer 19

In the absence of market distortions, what we produce and how we produce it is welfare maximizing when guided by the market -> this is the competitive outcome

Question 20

(12) Types of market distortions

Answer 20

• income inequality
• formation of cartels
• market power
• collusion
• price fixing

Question 21

(12) Different political ideologies of competition policy (US, Europe, Canada)

Answer 21

• US: collusive behaviour that compromises competition and/or the exercise of market power is categorically forbidden by law. They focus on anti-competitive behaviour, and they try to break it up.
• Europe: they are focused on increasing market (producers) concentration
• Canada: whether collusive behaviour or increasing market power is allowed or not depends on the circumstances. Canada is more flexible than US or Europe. Canada does not want to deny the economic benefits of the structure of an industry that, if allowed to be larger, would lower its costs. You need to look at the degree of competition in light of it’s circumstances

Question 22

(12) Consumer Surplus

Answer 22

Consumer surplus: the sum of the value captured by consumers insofar as inframarginal units are valued at more than the price. It is an economic measure of consumer satisfaction, calculated by analyzing the difference between what consumers are willing to pay for a good relative to its market price. A consumer surplus occurs when the consumer is willing to pay more for a given product than the current market price.

Question 23

(12) Fundamental Objectives of Competition Policy (2)

Answer 23

1. To prevent anti-competitive behaviour

2. To expand or to prevent the erosion of consumers’ surplus

Question 24

(12) The 5 Principle Characteristics of Pure Competition

Answer 24

1. Pure, “atomistic” competition implies that each supplier faces perfectly elastic demand
2. The supplier is thus a price taker
3. The individual supplier is powerless
4. Pricing strategy is meaningless
5. Excess profits (rents) are zero

Question 25

(12) Rents

Answer 25

Excess returns to “factors” (such as capital or labour) that arise because of a distortion in the market
In production, rents are always associated with Price > Marginal Cost

Question 26

(12) The Big International Issues (5)

Answer 26

• Classic protectionism: when nations use trade laws to protect domestic interests
• Neo-protectionism: when nations use more novel devices to protect domestic interests
• Anti-dumping: which can be justified only if dumping is itself a problem
• Excluded sectors: government procurement, defence, health, culture
• Regulation: standards

Question 27

(12) Price discrimination

Answer 27

• Selling at a lower price in the importer’s market than in the exporter’s market
• International price discrimination is thinly disguised as predatory pricing

Question 28

(12) Predatory Pricing

Answer 28

Systematically pricing in the import market below cost with a view to intimidating and/or eliminating rivals in the import market with a longer term view to establishing market power and higher prices

Question 29

(11) The Shell Case

Answer 29

• 1988 Shell Canada structured an international financing arrangement that resulted in substantial saving of Canadian corporate tax > this is a case of international tax arbitrage
• Shell Canada borrowed New Zealand dollars at a time when New Zealand was experiencing high inflation, and therefore, high nominal interest rates
• After borrowing in New Zealand dollars, Shell Canada immediately swapped those New Zealand dollars into US dollars while simultaneously entering into forward contracts to buy back New Zealand dollars to service the debt over the ensuing 5 years
• Reporting its Canadian tax liability, Shell claimed interest deductions based on the New Zealand interest rate – but the New Zealand interest rate included a substantial inflation component
• The New Zealand interest rate resulted in interest-deductions that exceeded interest deductions that would have applied to money borrowed in the US or Canada > Shell had constructed an inflated interest deduction
• Shell realized a foreign exchange gain that enjoyed preferential tax treatment in Canada
• After the case went all the way up to the Supreme Court, Shell eventual won

Question 30

(12) The Canadian Competition Act Contains:

Answer 30

 Prohibitions under the criminal law for the most damaging types of conduct (such as bid rigging and conspiracies to unduly lessen competition). These provisions are subject to criminal penalties
 Provisions for civil (or non-criminal) conduct, addressing commercial activities that are deemed anti-competitive only in limited circumstances. Examples are mergers or abuses or a dominant position that are likely to prevent or lessen competition substantially
 Elective two-track civil and criminal system addressing misleading advertising

Question 31

(12) enforcement of the competition law

Answer 31

o Canada has a 3-part system for the enforcement of the competition law: investigation, prosecution and adjudication
o At the end of the investigation by the Competition Bureau, the commissioner decides whether to refer the matter to the Competition Tribunal (for noncriminal matters) or to the Attorney General of Canada (for criminal matters).

Question 32

The Competition Tribunal Act

Answer 32

o Establishes the powers of the Competition Tribunal

o Empowered to hold hearings and decide matters under the noncriminal provisions of the Competition Act

Question 33

(12) GE/Honeywell case

Answer 33

• 2001: proposed merger between General Electric and Honeywell, two American firms
• The value of the deal was $42 billion
• Merger was approved by America’s antitrust authorities (with only minor changes)
• The proposed merger failed  squashed by the Competition Directorate of the European Union
• Mario Monti, the European Union’s Commissioner for Competition, believed that the combination of Honeywell’s cockpit controls with GE’s engines and powerful aircraft financing division would stifle competition. He would only approve the merger if Welch made extraordinary concessions
• There were little overlaps in the product lines of GE and Honeywell, and a combined company would be a powerful force  so other companies (like United Technologies, 1/3 of the trio that dominates jet engines) were determined to stop the deal
• What business is it of Europeans if 2 US companies want to merge? Among other things, GE alone employs 85,000 people in Europe and collected $25 billion in revenue there in 2000
• Some problems companies had with the merger:
o GE could now bundle engines and avionics in packages that other firms could not match
o GE’s role as a buyer of planes through GE Capital Aviation services (it’s finance and leasing subsidiary)  they could insist that those who buy aircrafts should buy both GE engines and Honeywell avionics  this would reduce consumer choice and stifle technological innovation

Question 34

(9) Net Benefit Test

Answer 34

Net Benefit Test: applies to large proposed foreign takeovers for mergers. Requires the prospective foreign investor to share confidential plans with the federal government and to demonstrate how these plans would be of net benefit to Canada, based on jobs, growing exports or improved productivity
o The net benefit test is secretive and unpredictable, and often prevents the government from clearly articulating why it would oppose a proposed investment
o If we were to screen acquisitions of Canadian own firms by other Canadian owned firms through the net benefit test we would feel that this is intrusive, BUT when the investor is foreign we feel it’s acceptable… why? The policy discriminates against foreign investors and against Canadians who want to sell to foreign investors

Question 35

(9) National Interest Test

Answer 35

National Interest Test
o Rather than asking companies to prove that their proposed investment would be of net benefit to Canada – require the federal government to articulate the public policy reasons that would prompt it to intervene
o It would be less obtrusive
o Allows the federal government the flexibility to intervene when a foreign investment might jeopardize Canadian laws, policies or objectives
o This would significantly reduce or eliminate obstacles to beneficial direct investment in Canada  increase attractiveness to foreign investors

Question 36

(9) Rules of origin

Answer 36

Rules of origin
o Within a free trade area it’s only free trade for the goods and services that meet the rules of origin (determine which goods are eligible for zero tariff within the free trade area).
o Goods need to have at least a certain amount of Mexican/America/Canadian/etc content
o Canada is having problems with the Europeans for cars – but Canadian cars are half Mexican or American so it doesn’t pass the rules of origin, so Canadians want to be accepted by Europeans on North American content
o Should we accept a suit made in Canada with all Italian fabric? Do the textiles need to come from Canada too?
o This may force companies to use inputs that they wouldn’t have used otherwise, so therefore it may force companies to be less competitive internationally
o If the rules of origin are restricted then we can’t benefit on it as much

Question 37

(9) Negative vs Positive list for trade negotiations

Answer 37

o Negative list: You open up trade on everything, but list what sectors will be excluded. Everything else is fair game. Old sectors can be explicitly excluded, but any new sectors are automatically included. (Canada does this)
o Positive list: Countries explicitly list the sectors they will open up, and the rest remains closed until further notice.

Question 38

(9) The Importance of Regulatory Cooperation

Answer 38

o Between Canada and the US there is a regulatory cooperation council that aims at facilitating mutual recognition
o If you want to sell something in Canada and then sell it in another country you may not be able to do that because of regulatory differences
o This council regulates the standards and harmonized them to eliminate small differences so it’s easier to trade
o There also has to be mutual recognition (ex. your product has a different rule but it doesn’t harm us if it comes into our country, so for the purpose of trade we are going to recognize your standard in these areas as long as you recognize our standards in these areas)

Question 39

(8) Economic risk (operational risk)

Answer 39

The risk associated with having a long standing business relation that spans boarders. These kinds of risks do not have readily accessible hedging mechanisms to protect themselves.

Question 40

(8) Transaction exposure/risk

Answer 40

Risk associated with transactions. Arises when a firm faces contractual cash flows that are fixed in a foreign currency. Whenever a firm has foreign-currency-denominated receivables or payables, it is subject to transaction exposure, and the eventual settlements have the potential to affect the firm’s cash flow position. There are ways to assure against this risk.
• Example: Say a Canadian company bills a British company for services. The invoice is for 1 million British pounds, due in 3 months. When the Canadian company receives the 1 million pounds in 3 months it will convert them into Canadian dollars at the spot rate of exchange at that time, but that future spot rate can not be known in advance  so the dollar value is not known.
o If the British pound appreciates the dollar receipt will be higher, but if it depreciates then the dollar value will be lower

Question 41

(8) Forward Hedge

Answer 41

Currency forward contracts. The firm may sell (buy) its foreign currency receivables (payables) forward to eliminate.
• Ex. Say you are to receive 10 mil euros in 1 year. You can sell forward your receivable to a bank. In 1 year you have to pay the bank 10 mil euros (which you will pay with the 10 mil euros you receive), and from the bank you will receive the Can $ amount with the 1 year forward rate (that was determined at the time of the deal, 1 year earlier) regardless of the spot exchange rate at the maturity date. You are assured of receiving a given dollar amount from the bank based on the forward rate, and so the dollar proceeds from the sale are not affected by the future changes in the exchange rate
• The dollar proceeds under the forward hedge will be higher than the unhedged position if the future spot exchange rate turns out to be higher than the forward rate, and the opposite will be true if the future spot rate becomes higher than the forward rate.

Question 42

(8) Money Market Hedge

Answer 42

Lending and borrowing in the domestic and foreign money markets. The firm may borrow (lend) in foreign currency to hedge its foreign currency receivables (payables), thereby matching its assets and liabilities in the same currency.
• You are you receive 10 mil euros in 1 year. You borrow euros now (10 mil euros discounted by 1 year by European interest rate). You then convert the borrowed euros to Canadian dollars at spot rate. Invest the Canadian dollars into treasury bills. In 1 year collect 10 mil euros and use it to repay the euro loan. Receive the maturity value of the dollars invested in treasury bills.

Question 43

(8) Options Hedge

Answer 43

the firm may buy a foreign currency call (put) option to hedge its foreign currency payables (receivables).

put option - if you are to receive 1 mil british pounds in 1 year and you want to convert to Can $ in 1 year. You can pay an option premium (price) to get a “put” option to SELL british pounds as a predetermined exercise price. you don’t have to sell them, you only sell them if the exercise price is better than the exchange rate in 1 year.

call option - if you want to buy british pounds in 1 year

options limits the downside risk while preserving the upside potential. you have the option whether or not you want to go through with the deal depending on the market in the future.

buy the option as an upfront cost, and then in 1 year you decide whether to exercise the option depending on the prevailing spot rate