PART 4 Flashcards
(45 cards)
What is the role of tax planning in the sustainability context, and how can it become problematic?
Purpose of Business Tax Planning
- Single-period goal: Maximize post-tax profit
- Multi-period goal: Maximize the net present value (NPV) of future after-tax income
Nature of Tax Planning
- Makes use of both intentional and unintentional tax advantages
- Can turn aggressive if it relies on:
- Artificial legal setups
- Financial channels
- Structures unrelated to real economic activity
International Tax Planning
- Exploits tax rate differences across countries
- Multinationals may shift profits to low-tax jurisdictions to reduce their global tax burden
What are the key dynamics and pros/cons of international tax competition?
Profit shifting: Firms use royalties, licensing, intangibles to route income to low-tax jurisdictions
Pros:
- Boosts efficiency and limits government overreach
- Enables tax choice via mobility (Tiebout)
- Reduces risk of capital being trapped by high taxes
Cons:
- Undermines funding for public services and education
- Limits income redistribution and social equity
What is the “Hold-Up Problem of Taxation” in a closed economy, and how does it affect education investment?
In a closed economy, individuals must decide whether to invest in education before the government sets tax policy.
Problem:
- The government may initially promise no taxation.
- Once individuals are educated (and immobile), the government has an incentive to tax them.
- If people expect to be taxed later, they might avoid investing in education altogether.
Conclusion: Without credible government commitment, fear of future taxation leads to underinvestment in education.
How does the Hold-Up Problem of Taxation worsen in an open economy?
In an open economy, the model adds a third step:
- Individuals decide to study.
- The government sets tax policy.
- Educated individuals choose whether to stay or emigrate.
Implications:
- If the government taxes, people may emigrate to avoid taxes, reducing the domestic tax base.
- If it doesn’t tax, people stay, but revenue is lower.
- This creates a disincentive to invest in education and makes taxation less effective.
Conclusion: Mobility makes the hold-up problem worse—leading to brain drain and discouraging educational investment.
What does the Laffer Curve illustrate, and what is its core insight about tax rates?
The Laffer Curve shows the relationship between tax rates and tax revenue.
It suggests there is an optimal tax rate that maximizes revenue.
Key insights:
- If tax rates are too low → revenue is insufficient.
- If tax rates are too high → people are discouraged from working or investing, which also lowers revenue.
Conclusion: There’s a sweet spot where tax rates are high enough to fund the government, but not so high that they harm economic activity.
How do multinational firms avoid taxes, and what efforts exist to curb this practice?
Tax avoidance by multinationals involves shifting profits to low-tax jurisdictions, often unrelated to actual business activity.
Examples: US firms shift profits to countries like Ireland and Luxembourg.
Efforts to reduce tax avoidance:
- OECD/G20 BEPS framework had limited impact.
- The global minimum tax (2021) is a more promising tool to reduce profit shifting.
Observation: Firm profitability often increases in countries with lower effective tax rates, indicating tax-driven profit allocation.
Is tax avoidance part of a fiduciary duty, and what are the media and reputational risks for firms?
Fiduciary Duty & Strategic Justification:
- Many firms view tax avoidance as legal, profit-maximizing behavior aligned with shareholder interests. Some even see it as a substitute for CSR or a signal to lower tax rates.
Media & Reputational Risks:
- High-profile cases show that aggressive tax strategies can backfire, leading to public backlash, loss of trust, and regulatory scrutiny.
- Behavioral Impact (ActionAid Study):
- Targeted firms increased their effective tax rate by 2.7%, paying £34M more in taxes—highlighting the influence of media and NGO pressure.
Conclusion: Since 2003, external pressure has driven greater corporate tax transparency and accountability.
What is the OECD BEPS framework, and how does it help reduce tax avoidance?
OECD BEPS is a global initiative to stop tax avoidance by multinationals shifting profits to low-tax countries.
3 Pillars:
- Coherence – Align tax rules to close loopholes (e.g. mismatches, interest deductions, harmful practices).
- Substance – Ensure companies pay taxes where real value is created (e.g. real operations, fair pricing).
- Transparency – Increase visibility through country-by-country reporting and disclosure of tax schemes.
Extra Focus:
- Address digital economy tax challenges and promote global adoption via international agreements.
What is the purpose of the EU’s DAC (Directive on Administrative Cooperation), and what do DAC1 to DAC6 include?
Purpose: The Directive on Administrative Cooperation (DAC) enhances tax transparency and cross-border cooperation to combat tax evasion and avoidance in the EU.
What Each DAC Covers:
- DAC1–2: Introduced cross-border tax data exchange, moving from request-based to automatic sharing of bank account info.
- DAC3–4: Increased corporate transparency by exchanging tax rulings and requiring country-by-country reporting from multinationals
- DAC5–6: Strengthened anti-abuse efforts through access to ownership data and mandatory disclosure of aggressive tax planning schemes.
Why It Matters: Requests for tax info nearly doubled post-DAC, helping the EU crack down on tax avoidance and improve tax fairness.
How does GRI 207 help integrate tax into sustainability reporting, and what does it require companies to disclose?
GRI 207 (2019) – Short Summary:
GRI 207 promotes tax transparency as part of responsible business conduct, helping companies reduce reputational risk.
Key Disclosures:
- 207-1: Tax strategy and policy
- 207-2: Governance and risk management
- 207-3: Stakeholder engagement on tax
- 207-4: Country-by-country reporting (CbCR)
Why It Matters: It builds trust, enhances transparency, and helps prevent reputational damage.
What must companies disclose under GRI 207-1 (Approach to Tax)?
Companies must explain:
- Whether a formal tax strategy exists and share it publicly if possible
- Who oversees the tax strategy and how often it’s reviewed
- How tax compliance is ensured
- How the tax strategy aligns with business and sustainability goals
What is a tax shield and how does it reduce taxes?
A tax shield is a reduction in taxable income from using deductible expenses like interest.
- Without deduction: Tax = 1,000 × 25% = 250
- With interest deduction (250): Taxable income = 1,000 – 250 = 750
Tax = 750 × 25% = 187.5
- Tax shield = 250 – 187.5 = 62.5
- This means the company saves €62.5 in taxes by deducting interest.
What’s the difference between accounting profit and taxable profit?
Accounting Profit (EBT):
- Shown in financial statements
- Based on accounting rules (before tax is deducted)
Taxable Profit:
- Calculated using tax laws
- Not shown in financial reports
- Basis for actual tax payment to authorities
Only accounting profit and tax expense are disclosed in financial statements—not taxable income.
What are the two components of tax expense in financial statements?
1. Current Tax Expense:
- Tax due based on taxable income
- Paid in the current period
2. Deferred Tax Expense:
- Results from temporary timing differences (e.g., different depreciation methods)
- Can create future tax assets or liabilities
Summary:
Tax expense = Current tax + Deferred tax
It reflects both taxes owed now and future adjustments.
What are the two types of deferred taxes and how do they differ?
1. Deferred Tax Liability (DTL):
- Means: Future tax payments
- Cause: Temporary taxable differences
- Arises when:
- Income is reported earlier in accounting than for tax
- Example: Accelerated depreciation in tax books
2. Deferred Tax Asset (DTA):
- Means: Future tax savings
- Cause: Temporary deductible differences
- Arises when:
- Expenses/losses are reported earlier in tax than in accounting
- Example: Loss carryforwards or tax-deductible provisions not yet in books
Summary:
- DTL = Pay more tax later
- DTA = Save tax later
What are temporary vs. permanent tax differences, and how do they affect deferred taxes?
1. Temporary Differences
- Definition: Timing differences between accounting and tax treatment of the same item
- Example: Depreciation differs under tax and accounting rules
- Impact: Deferred tax is recognized
2. Permanent Differences
- Definition: Items recognized only in accounting or only in tax
- Example: Fines, tax-exempt income
- Impact: No deferred tax is recognized
What is the difference between tax minimization, tax avoidance, and tax evasion?
1. Tax Minimization (Legal, accepted)
- Uses legal deductions, credits, and allowances within the law’s intent
- Involves genuine business transactions
- Examples: Claiming depreciation, deducting R&D, tax credits
2. Tax Avoidance (Legal, ethically questionable)
- Uses the letter, not the spirit, of the law
- Often uses artificial structures (e.g., tax haven subsidiaries)
- Transactions may lack real economic substance
- Major regulatory focus (e.g., OECD BEPS)
3. Tax Evasion (Illegal)
Criminal behavior to reduce taxes
Examples:
- Underreporting income
- Falsifying invoices/returns
- Hiding money offshore without disclosure
Note:
- Distinction between minimization and avoidance can be unclear
- Tax authorities increasingly emphasize substance over form
Also:
Deferred Taxes help with:
- Accurate timing of tax recognition
- Matching accounting income and tax expense
- Transparent view of future tax obligations/benefits
What are Hybrid Mismatch Arrangements (HMAs) and why are they problematic?
Two countries treat the same payment differently for tax purposes; enabling double deductions or untaxed incomes
- German Subsidary pays interest to UK parent structured as hybrid investemnts
- Interest seen as debt in G (deductible) and Uk parent sees this as equity
- Germany gets deduction and UK taxes nothing => no income tax
EU and Germany impose regulatiosn to stop this (would be illegal)
How do multinational companies use thin capitalization and intangibles to lower their global tax burden?
1. Thin Capitalization (Debt Shifting):
Firms fund subsidiaries with debt (not equity) to deduct interest in high-tax countries, lowering taxable income.
2. Intangibles & IP Planning:
Firms shift IP to low-tax countries and use inflated royalty payments to reduce taxes globally.
Example:
A Hong Kong company sells IP to a German firm via a loan; Germany gets deductions, Hong Kong sees no tax — enabling legal profit shifting without real business change.
What is the bottom line of multinational tax planning using thin capitalization and IP placement, and how are authorities responding?
Multinationals legally reduce taxes by:
- Placing debt in high-tax countries (to deduct interest)
- Placing intellectual property (IP) in low-tax countries (to shift profits)
These strategies exploit mismatches in international tax rules.
Response by Tax Authorities:
- Stricter transfer pricing rules (to align pricing with actual value creation)
- Interest deduction limits (to prevent excessive debt shifting)
- Anti-abuse regulations like: OECD BEPS framework, EU Anti-Tax Avoidance Directive (ATAD)
→ The goal is to close loopholes and ensure profits are taxed where value is created.
What is transfer pricing and why does it matter for taxation?
Sets internal prices for goods or services exchanged between a company’s divisions across borders, it affects where rpofits and taxes are reported
- influences how profits are allocated
- low prices shift profit to importing; high to exporting
=> By shifting profits to a higher tax country; overall tax paid increases
What is transfer pricing, why do companies use it, and what problems can it cause? Example Germany-France
Transfer pricing is the internal price set when different parts of the same company trade with each other across countries (e.g., a factory in France sells to a sales unit in Germany). These prices are not market-based but decided within the company.
Why do companies use it?
- To shift profits to countries with lower tax rates
- To reduce their total tax bill
- To allocate profits between parts of the company in different countries
Example (Toothbrush company):
- Total revenue: €100 (from selling toothbrushes)
- Total cost: €60 (€20 production + €40 sales)
- Profit = €40
This profit can be split between countries depending on the internal (transfer) price used.
Key point:
- Higher transfer prices shift more profit (and tax) to high-tax countries like France.
- Problem – When countries disagree: If France thinks it should tax €20 profit, and Germany wants to tax €38 profit, the total taxed income becomes €58 — even though the real profit is only €40 → this leads to double taxation.
- Solution: Countries should agree on transfer prices (called corresponding pricing) to avoid over-taxation and ensure fair tax distribution.
How do tax authorities regulate transfer pricing, and what OECD methods must companies use to justify their transfer prices?
Regulation: Arm’s Length Principle (OECD Art. 9.1)
- Transfer prices must reflect what two independent companies would agree to (as if they were not part of the same group).
- If not, tax authorities can make adjustments (e.g., leading to double taxation).
Solution: Apply OECD Transfer Pricing Methods
Companies must use one of the following to justify their prices:
1.Standard Methods (Preferred when comparable data is available)
- CUP (Comparable Uncontrolled Price): Use market price if similar goods are sold to outsiders.
- Cost Plus: Add a markup to production costs (e.g., France adds margin to manufacturing).
- Resale Price: Deduct a margin from the resale price to determine acceptable transfer value (e.g., for distribution in Germany).
2.Profit-Based Methods (Used when there are no reliable market comparisons)
- TNMM (Transactional Net Margin Method): Compare net profit margins to similar independent businesses.
- Profit Split: Divide the total profit (e.g., €40) based on each division’s functional contribution.
Goal: Ensure fair profit allocation across countries and avoid aggressive tax planning or penalties.
How did IKEA use transfer pricing to minimize taxes, and what were the effects?
Mechanism: National IKEA subsidiaries paid 3% royalties to Inter IKEA (in the Netherlands), lowering their local taxable income.
The royalties were then funneled through:
- Luxembourg (very low tax: 0.03% on €807.5m)
- Liechtenstein, where foundation income is not taxed
Effect:
- Profits were shifted from high-tax to low-tax countries.
- Legally reduced the global tax burden using intra-group charges and transfer pricing.
IKEA legally used transfer pricing to minimize tax liabilities by rerouting profits through low-tax jurisdictions.
