Tax Effects For Incomings Fall Term 2022 Slides

Tax Effects
Prof. Dr. Martin Fochmann
1
Part I
Introduction
Prof. Dr. Martin Fochmann 2

I.1 Taxes and Business Decisions
Tax Planning
• Taxes have a negative impact on economic activities

• They can be perceived as cost (comparable to wages or cost of
supplies)
• Taxes can affect different investment strategies and
substantially change their advantageousness
• Taxes can be the sole purpose of certain investments
→ Therefore tax planning is a major part of corporate

planning

Why Do Taxes Matter?
Example
• Assumptions:
 Interest rate: 𝑖𝑖 = 10%
 Cash flows:
t 0 1 2 3
CFt –3,000 1,440 1,140 1,000
• Net Present Value before taxes:

𝑛𝑛 𝐶𝐶𝐹𝐹𝑡𝑡
𝐶𝐶0 = −𝐼𝐼0 + 𝑃𝑃𝑉𝑉0 = −𝐼𝐼0 + � 𝑡𝑡
𝑡𝑡=1 1 + 𝑖𝑖
1,440 1,140 1,000
𝐶𝐶0 = −3,000 + + + = 2.55 > 0
1.11 1.12 1.13

Why Do Taxes Matter?
• Further assumptions:
 Tax rate: τ = 50%
 Interest rate after tax: 𝑖𝑖τ = 0.1 1 − τ = 0.05
 Straight-line depreciation (useful life: 3 years)
t 0 1 2 3
CFt –3,000 1,440 1,140 1,000
Dept 1,000 1,000 1,000
Tax Baset 440 140 0
Taxt 220 70 0
CFτ,t 1,220 1,070 1,000
• Net Present Value after taxes:

𝑛𝑛 𝐶𝐶𝐶𝐶𝑡𝑡τ 1,220 1,070 1,000
𝐶𝐶0τ = −𝐼𝐼0 + 𝑃𝑃𝑃𝑃0τ = −𝐼𝐼0 + � 𝑡𝑡
= −3,000 + + + = −3.75 < 0
𝑡𝑡=1 1 + 𝑖𝑖τ 1.051 1.052 1.053
→ If taxes are not considered, investment decision is biased! 5

Example: Shareholder value of a multinational company (MNC)
• Earnings Per Share (EPS) as a key indicator of a company’s

profitability and factor on the company’s share price
𝑁𝑁𝑁𝑁𝑁𝑁 𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖
𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 𝑃𝑃𝑒𝑒𝑒𝑒 𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 =
𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂 𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆
• Taxes directly reduce net income and therefore have a great

impact on the EPS
• Companies generating the same pre-tax profit can have a great
difference in EPS, when facing different effective tax rates
• Impact of a change in tax rates on EPS can be large

• The MNC shows the following financial key data:

Sales EUR 1,000 Mio
Profit before taxes EUR 100 Mio
Tax rate 30 %
Profit after taxes EUR 70 Mio
No. of outstanding shares 20 Mio
• Earnings Per Share = EUR 70 Mio / 20 Mio = EUR 3.50

• Goal: increase EPS by EUR 0.25 to EUR 3.75 (= 7.14 %)

• Several alternatives, in particular:
 Increase sales by EUR 71.4 Mio and thus profits by EUR 7.14 Mio
EUR 107.14 Mio x (1 – 30%) / 20 Mio = EUR 3.75
 Reduce tax rate by 5 percentage points to 25 %
EUR 100 Mio x (1 – 25%) / 20 Mio = EUR 3.75
• In this simple example, a decrease of 5% in the tax rate has the
same impact on the EPS ratio as an increase of sales by 7 %
(i.e., EUR 71.4 Mio)

Influence of Taxes on Management Decisions
• Economics, business in particular, is about making

choices
 Weighing different choices or alternatives
 Choose the best alternative given target function and
constraints
• Tax planning: make business choices that achieve the
highest surplus net of tax
 Increase after tax cash flows and the company’s market
value (investor’s wealth)
 tax planning ≠ “minimization of tax payments” as an
absolute goal
Source: Endres and Spengel (2015), p. 23.

• In an international context, the importance of taxation

increases because all taxes as well as the
consequences of different corporate tax systems must
be considered when taking a decision
• International tax planning aims at taking advantage

of tax rate as well as tax base differentials across
countries within the overall corporate strategy of a
multinational company

I.2 Tax Basics
Tax Definition
• Section 3 of the German Fiscal Code (Abgabenordnung):

“Taxes are payments of money, other than payments made in
consideration for the performance of a particular activity, which are
collected by a public body for the purpose of raising revenue and
imposed by that body on all persons to whom the characteristics on
which the law bases liability for payment apply; the raising of revenue
may be a secondary objective.”
• Taxes are payments
 regulated by law
 made to a public body
 without receiving goods or services in return

I.2 Tax Basics
Fundamental Objectives of Taxation
• Revenue collection
 Taxes are levied to raise revenue to finance public expenditure
• Political objectives
 Redistribution function: wealth and taxable income is reallocated from
the rich to the poor (e.g., progressive income tax, deduction of charity
donations  see next slide)
• Economic objectives
 Promote business or private investments
 Use of ecology-friendly technical equipment
 Tax incentives: accelerated depreciation, reduced tax rates

I.2 Tax Basics
Fundamental Objectives of Taxation
Progressive tax
𝑇𝑇 100,000 ⟹ 32,863
� 32,800
𝑇𝑇 10,000 ⟹ 63
𝑇𝑇 100,000 ⟹ 34,000 17,150
� 34,300
𝑇𝑇(10,000) ⟹ 300 17,150
Deduction of charity donations
30,000 𝜏𝜏 = 30% donation: 1,000
no deduction: 30,000 × 30 % = 9,000

+ 1,000
10,000
donation is completely tax deductible: Δ: 300
30,000 − 1,000 × 30% = 8,700
+ 1,000 1,000 × 30%
9,700
I.2 Tax Basics
Objectives of Income Taxation
• Personal income tax is payable by all individuals in a country

on their income
• Fairness plays a central role
• Two central criteria:
 Principle of equity
• Horizontal equity
• Vertical equity
 Ability-to-pay principle

I.2 Tax Basics
Horizontal Equity
• Idea: given the same conditions and circumstances, people

should be treated equally
• Horizontal equity is achieved if two people with the same
income pay the same amount of tax regardless of the source of
income
• Example:
Person A earns EUR 100,000 employment income. Person B earns EUR 100,000
interest income. Both should pay the same amount of tax. This means that the
same tax rate should apply for both and that all income is determined in the same
manner.
• Example for a violation of the pure horizontal equity principle:
Person C wins EUR 100,000 in a lottery and has no other income. If lottery
income is not taxed, C pays no tax.
I.2 Tax Basics
Horizontal Equity
• Example with two periods
T(50,000) = 12,500 (25%)

T(100,000) = 34,000 (34%)
T(0) = 0 (0%)
period 1 period 2
Teacher income 50,000 50,000
tax 12,500 12,500 ⟹ 25,000
Sportsman income 100,000 0

tax 34,000 0 ⟹ 34,000

I.2 Tax Basics
Vertical Equity
• Idea: given different conditions and circumstances, people

should be treated differently
• Vertical equity is achieved if people earning higher income are
taxed absolutely and relatively higher than people with lower
income
• Examples:
In country A, income of individuals is subject to a 10% tax rate. A person with
EUR 10,000 income pays EUR 1,000 income tax; a person with EUR 100,000
income pays EUR 10,000 income tax. The person with the higher income pays
absolutely higher taxes. However, relatively, they are subject to the same tax rate.
In country B, income up to EUR 10,000 is subject to a 10% tax rate. Persons with
higher income are subject to a 20% tax rate on all income. Comparing again the
two income levels, the person with the higher income pays absolutely (EUR 1,000
vs. EUR 20,000) and relatively (10% vs. 20%) higher taxes.
18
I.2 Tax Basics
Ability-To-Pay Principle and Net Principle
• Ability-to-pay principle: people should be taxed according to

their financial capacity in order to contribute to the provision
of public goods and services
 Net income serves as an indicator of measuring the economic power of
each taxpayer
• Net principle:
 Only net income is taxable
 All expenditures related to taxable income generation and all private
expenses necessary for subsistence must be deductible from the tax
base
 Accordingly, losses must reduce the taxable income since losses only
arise when expenditure exceeds gross income

I.2 Tax Basics
Example: Deduction of Expenditures/Losses
• Income
 Positive income (gain): 100
 Negative income (expenditure/loss): -20
 Tax rate: 50%
• Income before taxes: 100 – 20 = 80
• Deduction allowed (e.g., unrestricted loss offset):
 Income after taxes: 100 – 20 – (100 – 20) x 0.5 = 40
 Separation of tax effects: 100 x (1 – 0.5) – 20 x (1 – 0.5) = 50 – 10 = 40
 Taxation reduces gains and losses
• Deduction not allowed (e.g., no loss offset):
 Income after taxes: 100 – 20 – (100 – 0) x 0.5 = 30
 Separation of tax effects: 100 x (1 – 0.5) – 20 x (1 – 0) = 30
 Taxation reduces gains, but not losses
I.2 Tax Basics
Loss Offset
• Ability-to-pay and net principle are generally valid for a

person’s lifetime tax payments
• Problem: income taxes are levied annually
• Expenses in one year to earn income later thus have to be
deductible from the tax base in that year
 Same holds for losses
• For taxpayers it would be ideal, if they receive a direct tax
refund in case of a loss
• However, no country allows an unrestricted loss offset
• Countries prefer to allow loss carry-backs and
carry-forwards
I.2 Tax Basics
Example: No Loss Offset
• Assumptions:
 Tax rate: 25%
 Interest rate after tax: 𝑖𝑖τ = 0.05
t 1 2 3
CFt 100 -100 100
Tax Baset 100 0 100
Taxt 25 0 25
𝐶𝐶𝐶𝐶𝑡𝑡τ 75 -100 75
• Sum of cash flows after taxes: 50

𝐶𝐶𝐶𝐶𝑡𝑡τ
• Present Value after taxes: 𝑃𝑃𝑃𝑃0τ = 𝑛𝑛
∑𝑡𝑡=1 = 45.51
1+𝑖𝑖τ 𝑡𝑡
I.2 Tax Basics
Example: Unrestricted Loss Offset
t 1 2 3
CFt 100 -100 100
Tax Baset 100 -100 100
Taxt 25 -25 25
𝐶𝐶𝐶𝐶𝑡𝑡τ 75 -75 75

• Present Value after taxes: 𝑃𝑃𝑃𝑃0τ = 𝑛𝑛
∑𝑡𝑡=1 = 68.19

I.2 Tax Basics
Example: Loss Carry-Forward
t 1 2 3
CFt 100 -100 100
Carry-Forwardt --- +100 ---
Loss offset due to Carry-Forwardt --- --- -100
Tax Baset 100 0 0
Taxt 25 0 0
𝐶𝐶𝐶𝐶𝑡𝑡τ 75 -100 100

τ
𝐶𝐶𝐶𝐶
• Present Value after taxes: 𝑃𝑃𝑃𝑃0τ = ∑𝑛𝑛𝑡𝑡=1 𝑡𝑡
= 67.11
I.2 Tax Basics
Example: Loss Carry-Back
t 1 2 3
CFt 100 -100 100
Carry-Forwardt --- --- ---
Loss offset due to Carry-Forwardt --- --- ---
Carry-Backt --- +100 ---
Tax Baset 100 0 100
Taxt 25 0 25
Tax Refund due to Carry-Backt --- 25 ---
• Tax refund due to carry-back in t = 2:

 Tax in t = 1 before carry-back: 100 x 25% = 25
 Modified tax for t = 1 after carry-back: (100 – 100) x 25% = 0
 Tax refund: difference between original and modified tax (25 – 0 = 25)
• Present Value after taxes: 𝑃𝑃𝑃𝑃0τ = ∑𝑛𝑛𝑡𝑡=1 1+𝑖𝑖τ 𝑡𝑡
= 68.19 25
I.2 Tax Basics
Example: Loss Carry-Back and Carry-Forward
t 1 2 3
CFt 100 -100 100
Carry-Forwardt --- +80 ---
Loss offset due to Carry-Forwardt --- --- -80
Carry-Backt --- +20 ---
Tax Baset 100 0 20
Taxt 25 0 5
Tax Refund due to Carry-Backt --- 5 ---
• Tax refund due to carry-back in t = 2:

 Tax in t = 1 before carry-back: 100 x 25% = 25
 Modified tax for t = 1 after carry-back: (100 – 20) x 25% = 20
 Tax refund: difference between original and modified tax (25 – 20 = 5)
• Present Value after taxes: 𝑃𝑃𝑃𝑃0τ = ∑𝑛𝑛𝑡𝑡=1 1+𝑖𝑖τ 𝑡𝑡
= 67.33 26
I.2 Tax Basics
Elements of a Tax

I.3 Tax Scale
Tax Liability and Tax Rates
• Definitions:
 Tax base (taxable income): y
 Tax liability: T(y)
𝑇𝑇(𝑦𝑦)
 Average tax rate: 𝐴𝐴𝐴𝐴𝐴𝐴 𝑦𝑦 = = 𝑡𝑡𝐴𝐴
𝑦𝑦
𝜕𝜕𝑇𝑇(𝑦𝑦)
 Marginal tax rate: 𝑀𝑀𝑀𝑀𝑀𝑀 𝑦𝑦 = = 𝑡𝑡𝑀𝑀
𝜕𝜕𝑦𝑦
𝜕𝜕𝐴𝐴𝐴𝐴𝐴𝐴(𝑦𝑦)
• Proportional tax: 𝐴𝐴𝐴𝐴𝐴𝐴 𝑦𝑦 > 0 and =0
𝜕𝜕𝑦𝑦
𝜕𝜕𝐴𝐴𝐴𝐴𝐴𝐴(𝑦𝑦)
• Progressive tax: 𝐴𝐴𝐴𝐴𝐴𝐴 𝑦𝑦 > 0 and >0
𝜕𝜕𝑦𝑦

I.3 Tax Scale
Flat Tax

I.3 Tax Scale
Flat Tax with Basic Allowance (Indirect Progression)

I.3 Tax Scale
Progressive Income Tax (Direct Progression)

I.4 Tax Compliance
Tax Collection, Enforcement and Compliance
• Tax collection can be in the form of

(1) a tax assessment with tax filing by the person liable to tax
• Business taxes are usually levied by tax assessment
(2) withholding taxation where the tax is withheld at source
• Examples: income taxes on employment income, taxes payable on capital
income (e.g., interest income)
• Tax enforcement means all measures taken by public bodies to
ensure that taxes are paid on time
• Compliance: taxpayer acts in line with the tax law
• Compliance cost: cost for the taxpayer that arise to comply
with the tax law and include the cost of fulfilling all
documentation requirements imposed by law
I.4 Tax Compliance
Tax Strategies
Tax Strategies
Tax Evasion Tax Avoidance
“Acceptable” “Aggressive”
• Any action by the

taxpayer to circumvent • Regular, legal and • Lack of business purpose,
taxation by illegal means legitimate use of existing taking advantage of
with the sole purpose of tax provisions with the loopholes in the law
escaping tax payments objective of optimizing
despite an existing the tax burden
liability • The term tax planning is
often used in the context
of ‘acceptable’ tax
avoidance
Illegal! 33
I.4 Tax Compliance
International Tax Planning
Substantive Tax Planning Formal Tax Planning
• Economic activity is changed • A given structure of economic

substantially or given up entirely activity is treated in the most tax-
• For example: investment in a high- efficient way
tax country is moved to a low-tax • For example: investment in a high-
country (investment shifting) tax country is financed with debt
instead of equity in order to benefit
from the deductibility of interest
payments from taxable income
(profit shifting)

I.4 Tax Compliance
Sources of Tax Legislation
• National sources:
 Constitutional framework of a country (e.g., fundamental rights)
 Domestic tax law (e.g., tax act)
 Tax jurisprudence or tax case law (e.g., court decisions)
 Administrative decrees (e.g., directives of superior administrative
authorities to their subordinates and functionaries – usually only
binding for the administration itself)
• International sources:
 International tax treaties (e.g., bilateral double tax treaties)
 Primary EU law (e.g., free movement of worker and capital, freedom of
establishment)
 Secondary EU law (e.g., Parent Subsidiary Directive)

Part II
International
Company Taxation

II.1 Legal Structures of Company Taxation
Legal Forms and Taxation
• Taxpayers organize their economic activities in different legal

forms: proprietorship, partnerships and corporations
• Sole proprietors: natural persons
• Partnerships: limited legal personality
 Partners can contract in the name of partnership and the partners
 In some countries: full legal personality
• Corporations: full legal personality (legal persons)
 A corporation, represented by its directors, can contract with third
parties as well as with its own shareholders
• Tax law distinguishes between natural and legal persons: both
are taxable subjects

Legal Forms and Taxation
• Natural persons, partnerships and corporations may act as

shareholders of corporations and partners of partnerships
corporation A/
partnership
50 % 25 % 25 %
corporation B natural person partnership

Legally Distinct Entities
• Corporation is taxed independently of its shareholders

 Since corporation is a legally distinct entity, its profit (taxable income)
is subject to corporation tax (usually at a proportional tax rate)
 If corporation distributes its profits as dividends to its shareholders,
those persons may be taxed on the dividends received
 If the profits are not distributed, corporate income is sheltered from an
income tax charge on the shareholder
• Separate entity approach:
 Each entity is taxed separately (at least two levels of taxation)
 Also called: corporate principle or deferral principle

Economic Double Taxation of Profits
• Corporate profits suffer from economic double taxation

 From a legal perspective, two taxpayers (corporation and shareholder) are
separately taxed
 From an economic perspective, dividend is taxed twice
• Mitigation (or even completely elimination) of economic double
taxation depends on corporation tax system
 Many countries (e.g., Germany) grant shareholder relief by partly
exempting dividend income or by reducing the tax rate
• Example II.1:
The natural person P (tax rate: 40%) owns a 100% shareholding in C Corporation (tax
rate: 40%). P provides 1,000 equity capital to C Corporation, which earns a profit of
100. C Corporation distributes its after tax profit to P. The dividend received by P is
included in P’s taxable income.
1. Dividend is completely included in P´s taxable income.
2. In order to reduce economic double taxation, P is allowed to deduct 50% of the
dividend from his taxable income.
Economic Double Taxation of Profits
II.1.1 II.1.2
corporation 100 100 tax base
- 40 - 40 corporate tax
= 60 = 60
shareholder 60 60 dividend
60 50 % x 60 = taxable
30 income
- 24 - 12 income tax
= 36 = 48
(total tax: (total tax:
40 + 24 = 64) 52)
Shareholder Contracts
• Contracts concluded by corporations and shareholders under

civil law are accepted for tax purposes
• For example: Shareholder concludes loan contract and provide
debt capital to corporation (debt financing)
 Corporation can deduct interest payments
 Shareholder’s taxable income includes interest payments
 Economic double taxation does not occur
• Example II.2:
Consider a shareholder loan substituting equity capital of 1,000 and
assume an interest rate of 10%. The corporation earns a profit before
interest payments of 100 and owes interest of 100, which reduces C
Corporation’s taxable income. P includes the interest payments received
into its taxable income.

Shareholder Contracts
II.1.1 II.1.2 II.2

corporation 100 100 0 (=100-100) tax base
- 40 - 40 0 corporate tax
= 60 = 60 =0
shareholder 60 60 0 dividend
60 50 % x 60 = 100 taxable
30 income
- 24 - 12 - 40 income tax
= 36 = 48 = 60
(total tax: (total tax: (total tax:
40 + 24 = 64) 40 + 12 = 52) 40)
Pass-Through Entities
• Profits earned by natural persons (sole proprietors) are burdened

with individual income tax
• In most countries, individual income tax is progressive
• In countries where partnerships have a limited tax legal personality,
partnership is not regarded as a taxable subject
 Partnerships are pass-through (transparent) entities
 Profits are allocated to the owners dependent on their share
 Each owner (partner) pays taxes on his own profit share as part of his own
income
• Pass-through taxation (transparent taxation):
 Income derived in the business is passed through to the owner and taxed by
him (only one level of taxation – business itself is not subject to tax)
• Sole proprietors and natural persons as partners of a partnership are
taxed in the same way
• Economic double taxation of profits does not occur
Partner Contracts
• Sole proprietor is not able to conclude contracts with his firm

• Partnerships are able to conclude contracts with their partners
 For example: loan contract
• Interest payments to partners reduce partnership profit
• However, interest payment is (usually) classified as partnership income
under income tax law
• Partners and sole proprietors are effectively treated the same way
• Example II.3:
A and B are partners of A & Co., a general partnership. Both partners
hold 50% of the partnership’s capital. A & Co. earns a profit of 200. A and
B both grant a loan of 1,000 to A & Co. at 10% interest rate.
• In general, partners in a partnership do not save income taxes
when switching from partnership capital to loan capital (in
contrast to corporations)
Partner Contracts
no debt with debt

partnership 200 200
-2 x 100
0
50 % 50 % 50 % 50 %
A B A B
100 100 0 0
100 100
= 100 = 100
40 % -40 -40 - 40 - 40
60 60 60 60

II.2 Corporation Tax
Corporation Tax Base
• Taxable income (profit or loss) of a corporation is the net

surplus of revenue over expense usually based on accrual
accounting
 Accrual accounting: recording income (expense) when earned
(incurred)
 Cash accounting: recording the transaction when paid
• All revenues are taxable and all expenses are tax-deductible
unless tax law exempts revenues from tax base or disallows
specific expenses
• Depreciation:
 Fixed assets (with useful life n > 1 year) are depreciated on the basis of
historical cost over their expected useful life
 Straight-line and declining-balance depreciation method

• Deductibility of expenses
 Many payments from corporations are tax-deductible
• For example: salaries, rental payments, interest payment
 Certain expenses may not be deductible
• Fines and corporation taxes
• Profit distribution (to shareholders) are usually not deductible
 Deductibility of expenses offers scope for tax planning
• Incentive to transfer profits to shareholders via contracts generating
deductible expenses instead of paying non-deductible dividends
• Tax law restrictions prevent corporations from excessively reducing their
tax base in this way (e.g., at arm’s length principle)
• Loss deduction
 Immediate and unrestricted loss offset is usually not provided
 Alternatives: loss carry-back and carry-forward 48
Loss Offsetting Rules for Corporations

Loss Offsetting Rules for Individuals

Corporation Tax Rate
• Corporation tax is charged at a single fixed rate in general

(flat tax)
• In some countries, a local tax is additionally raised
• Example: Germany
 Corporate tax rate: 15%
 Trade tax:
• Rate is determined by the uniform factor 3.5% and the local multiplier set
by each local authority (minimum: 200%, mean: 403% (2019))
• Average trade tax rate: 3.5% x 403% = 14.105%
 Solidarity surcharge:
• 5.5% of corporation tax due (5.5% x 15% = 0.825%)
 In total: 29.93%

Corporation Tax Rate
Tax Burden (in %)

on Corporate Profits
including Local Taxes
(2021).
Source: Federal Ministry of

Finance (2022): Die
wichtigsten Steuern im
internationalen Vergleich
2021.
52
Corporation Tax System
• Corporate profits are taxed twice whereas profits of

partnerships/sole proprietors are only taxed once
• Most income tax systems address economic double taxation of
corporate profits at the shareholder level
• Withholding Tax
 Shareholders are taxed on the dividend by means of a withholding tax
deducted from gross dividend paid
 Corporation collects this tax and forwards the tax revenue to tax
authority
 Two alternatives:
• Tax is final burden  no further obligation
• If not: amount withheld can be credited against the shareholder’s income
tax due on the dividend
• Shareholder Taxation
 Corporate shareholders:
• Dividends received are tax-free in general
• No economic double taxation for inter-corporate dividends as long as the profits do
not leave the corporate sphere
• Special rules may apply (Germany: 5% of dividend is disallowed as a deductible
expense; only 95% of dividend is tax-free)
 Natural persons as shareholders
• Further income tax on dividends
• Dependent on the corporation tax system, corporation tax is integrated into
individual income taxation to avoid/mitigate economic double taxation
• Tax systems:
1. Classical system with full double taxation
2. Double taxation avoidance systems
3. Double taxation mitigation systems (shareholder relief systems)

• Classical System
 Full double taxation
• Double Taxation Avoidance Systems
 Shareholder Level
• Full imputation: Imputing the corporate income tax to the shareholder’s personal income tax
• Tax exemption: Exempting the dividend income on the shareholder level from personal income
tax
 Corporate Level
• 100% dividend deduction: Deducting the dividend payment from the corporate income tax base
• Split rate system: 0% tax rate on distributed profits
• Double Taxation Relief Systems (Mitigation Systems)
 Shareholder Level
• Partial imputation: Imputing the corporate income tax partially to the shareholder’s personal
income tax
• Shareholder Relief:
1. Partially exempting the dividend income on the shareholder level from personal income tax
2. Levying a reduced tax rate on dividend income on the shareholder level
 Corporate Level
• <100% dividend deduction: Deducting the dividend payment partially from the corporate
income tax base
• Split rate system: Applying a split rate system with a reduced tax rate on distributed profits
(>0%)
Source: Endres
and Spengel 57
(2015), p. 105.
Group Taxation
• Tax law of all countries distinct between corporation and its

shareholders
• Special tax rules (which can differ across countries) apply to
groups of companies
• Under group taxation rules, group income is taxed in total
instead of taxing each group member individually
• Main advantage:
 Losses can be transferred from one company to another
 If transferred losses are absorbed by profits, the group enjoys an
immediate loss offset
• Requirements of group taxation regimes (in general):
 Affiliate companies are domestic corporations
 Subsidiaries are controlled by the parent
Group Taxation
Country X
Parent
Company
0
Holding
Corporation
Sub A Sub B
+100 -100
Country Y
Group Taxation
Group No Group
Gain scenario
Taxation Taxation
Subsidiary (corporation)
Profit 100.00 100.00
− Trade tax (local multiplier 400%) --- 14.00
− Corporation tax (15%) --- 15.00
− Solidarity surcharge (5.5% of corp. tax) --- 0.83
= Transfer/dividends 100.00 70.17
Parent company (corporation)
Transfer/dividends 100.00 70.17
Taxable (100%/5%) 100.00 3.51
− Trade tax (local multiplier 400%) 14.00 0.49
− Corporation tax (15%) 15.00 0.53
− Solidarity surcharge (5.5% of corp. tax) 0.83 0.03
= Income after taxes 70.17 69.12
Sum of taxes 29.83 30.88
Group Taxation
Group No Group
Loss scenario
Taxation Taxation
Subsidiary (corporation)
+ Loss -100.00 -100.00
+ Absorption losses +100.00 ---
= Taxable income 0.00 -100.00
Loss carry-forward --- 100.00
Parent company (corporation)
+ Absorption losses -100.00
+ Own profits +100.00 +100.00
= Taxable income 0.00 +100.00
− Trade tax (local multiplier 400%) 0.00 14.00
− Corporation tax (15%) 0.00 15.00
− Solidarity surcharge (5.5% of corp. tax) 0.00 0.83
Sum of taxes 0.00 29.83
II.3 International Double Taxation
Limited and Unlimited Tax Liability
• Countries levy taxes on the income of residents (legal and

natural persons) and non-residents
• Personal income tax
 Unlimited tax liability applies to natural persons who are residents
(e.g., living there) of a country (residence country)
 Limited tax liability applies to natural persons who are not residents of
a country, but with income from sources there (source country)
• Corporate income tax
 Unlimited tax liability if company has its legal seat (registered office)
and/or place of management in a country (residence country)
 Limited tax liability if company neither has its legal seat nor place of
management in a country, but with income from sources there (source
country)
• Unlimited tax liability

 Worldwide income is taxed (worldwide income principle)
 Income from all sources and locations are taxed in this country
• Limited tax liability
 Source taxation (territorial income principle)
 Taxpayer is subject to tax only on income from that source country
under the local rules
 For example
• Corporation performs economic activities in a foreign country through a
branch (profits attributed to branch are subject to tax in source country)
• Subsidiary located in the source country pays dividends to its parent
company located in another country (source country may establish limited
tax liability to the recipient of this income and levy a withholding tax)

Country A Country B
Border
Parent Subsidiary
unlimited tax liability unlimited tax

in country A Dividend liability in country B
+ limited tax liability in

country B
Subsidiary is an own corporation (legally distinct entity)

and is taxed separately.

Country A Country B
Border
Corporation P.E. of Corporation
unlimited tax liability no unlimited tax

in country A Profit liability in country B
+ limited tax liability in

country B
P.E. is not an own corporation (no legally distinct entity)

and is not taxed separately.
P.E. is a fixed place of business through which the business of an

enterprise is wholly or partly carried on (e.g., branch, office, factory)
Legal Double Taxation
• Example II.5:
A corporation has its legal seat and place of management in country A. It
receives dividends from a subsidiary in country B and rental payments for real
estate located in country C.
• Legal double taxation occurs if two countries levy a tax on the
same taxable object
 Unlimited and limited tax liability
 Double unlimited tax liability
• For example: corporation has its legal seat in Germany and its place of
management in Great Britain
 Double limited tax liability
• For example: Polish branch of a German corporation receives dividends
from a French subsidiary (corporation is subject to limited tax liability in
France and Poland as dividends are included in the Polish branch’s profit)
Legal Double Taxation
Subsidiary
Dividend
France
Parent P.E. Dividend

is part of
Germany Poland P.E.
profit
unlimited tax liability in Germany
limited tax liability in France
limited tax liability in Poland

Methods to Avoid Legal Double Taxation
1. National income tax law aims at reducing or avoiding legal

double taxation
2. Double taxation treaties (bilateral contracts)
 Contracting countries have agreed to avoid double taxation
 International law ranks higher than national law
 Treaty restrict the taxing right of the source country and oblige the
residence country to reduce its tax claim to eliminate any legal double
taxation
3. Tie-breaker rule
 Taxpayers are resident in both countries (e.g. if a corporation’s seat and
place of effective management differ)
 Rule allocates the taxing right to one of the contracting parties (here:
country where place of effective management is located)
OECD Model Treaty
• Most double taxation treaties are based on the model treaty of

the OECD
• Main purpose: give guidance to tax treaty negotiators when
concluding their own treaties
• Two fundamental principles:
 Taxing right of the source country is acknowledged, but may be
restricted
 Taxing right of the residence country is confirmed, but is conditional on
the obligation to eliminate possible double taxation

Source Country
• Unlimited taxing rights

 Income from real property (Art. 6 OECD-MT)
 Profits of permanent establishments (Art. 7 OECD-MT)
• Restricted taxing rights
 Dividends paid by a resident company to non-residents (Art. 10 OECD-MT)
• A withholding tax rate up to 5% of the gross amount is allowed if the shareholding
exceeds 25% and is held by a corporation
• A withholding tax rate up to 15% of the gross amount is allowed in all other cases
 Interest payments paid by a resident company to non-residents (Art. 11 OECD-MT)
• A withholding tax rate up to 10% of the gross amount is allowed
• Non-existent taxing rights

 Royalties paid to non-residents (Art. 12 OECD-MT)
 Capital gains on shareholdings of non-residents in resident corporations
(Art. 13 OECD-MT)
Residence Country
• Residence country has the right to tax worldwide income of resident

taxpayers
• If a taxpayer is resident in both countries, tie-breaker rules determine the
tax residence (Art. 4 OECD-MT)
• Business profits are taxed in state of residence of a company unless profits
are attributable to a permanent establishment in source country (Art. 7
OECD-MT)
• Residence country avoids legal double taxation by granting relief for taxes
paid in the source country
• Two methods to avoid legal double taxation
 Exemption method (Art. 23A OECD-MT)
 Credit method (Art. 23B OECD-MT)

Exemption Method (Art. 23A OECD-MT)
• Residence country exempts foreign income from domestic tax base

• Only the source country taxes the income
 Tax rate and tax base of source country determine tax burden
 Foreign losses are relieved in the foreign country
 Residence country forgoes tax revenue related to the foreign income but does not
relieve foreign losses
• Exceptions:
 Tax clauses: foreign income must be burdened with foreign taxes
 Activity clauses: foreign income must be derived from activities which are not seen
as tax avoidance activities
• German tax treaties, as a rule, grant exemption for real property, business
profits and income from self-employment
• Double tax treaties may exempt foreign dividends received by a resident
corporation if minimum shareholding requirements are fulfilled (international
affiliation privilege)
 However: corporation tax law often grants unconditional exemption of all kinds of
dividends
Credit Method (Art. 23B OECD-MT)
• Foreign income is included in the domestic tax base

• Foreign income tax paid on foreign income is credited against
the domestic income tax
 Tax revenue is shared between both countries
• German tax treaties: dividends and interest income
• The foreign tax credit applies to
 the foreign income tax due
 on the same income
 of the same taxpayer
 in the same period as the domestic income tax

source country: 100 residence country: 100

20% tax - 20 30% 30
tax credit - 20
additional tax 10
total tax: 20 + 10 30
source country: 100 residence country: 100

40% tax - 40 30% 30
tax credit -30
additional tax 0
total tax: 40 + 0 40
tax credit = min { foreign tax due ; domestic tax due } 74
• Tax credit is limited and is determined by the minimum of

 amount of foreign taxes paid
 amount of domestic taxes due on the foreign income
• Losses
 On the worldwide income principle, foreign losses as well as foreign
profits are included in the domestic income
• Restrictions: per country limitation, income basket limitation

Tax credit = min { foreign tax due ; domestic tax due }
A B C
(home) 100 100
30 % 35 % 20 % total tax
no per 200 x 30 % = 60 35 20 60
country 60 – min{35+20;60} = 5
limitation
per country 100 x 30 % = 30 35 35 (excess credit)
limitation 30 – min{35;30} = 0
100 x 30 % = 30
30 – min{20;30} = 10 20 30
65

II.4 International Profit Allocation
Transfer Pricing and Arm’s Length Principle
• MNCs invest in several countries through

 Legally distinct corporations (subsidiaries) or
 Legally dependent branches (permanent establishments)
• Countries tax the profits based on
 Unlimited tax liability (subsidiary) or
 Limited tax liability (permanent establishment)
• Overall profit of a MNC has to be apportioned to the countries
where its subsidiaries or permanent establishments are located
• Dealing at arm’s length principle
 Conditions made or imposed between associated parties (controlled
transactions) are not supposed to differ from those which would have
been agreed upon by independent parties (uncontrolled transactions)
 If the transfer price differs from the market price, the taxpayer’s income
has to be adjusted on the basis of the market price
77
Transfer Pricing and Arm’s Length Principle
A B
50 % 10 %
revenue 200 200 goods revenue 120 150

cost 120 150 Parent Subsidiary cost 100 100
tax base 80 50 120 tax base 20 50
tax 40 25 150 tax 2 5
TP: 120 TP: 150

42 > 30

Shortcomings of the Arm’s Length Principle
• Key assumption: comparability of controlled transactions with

uncontrolled transactions
• Problem: market prices of comparable uncontrolled
transactions are often non-existent
 Most goods transferred and services provided are firm-specific and,
thus, not traded by independent parties in markets
 Example:
• Assume a foreign subsidiary produces a product based on research and development
activities, undertaken by the domestic parent. Based on a license agreement, the
foreign subsidiary pays the stipulated price (transfer price) to the parent for the
know-how transferred. Under the arm’s length principle, the transfer price for the
know-how should conform to the market price of a comparable transaction.
However, because know-how is a firm-specific asset which is not traded on the
market, a market price cannot be established.
• Impossible to correctly split up the company’s total profit 79

Subsidiary
• Corporation tax law follows separate entity accounting which is also

applied to internal transactions of the MNC
• Affiliated corporations are legally distinct entities and can enter into legal
contracts
• To determine subsidiary’s profit, internal transactions are accounted for on
the basis of transfer prices stipulated in legal contracts
 Transfer prices have to conform to the arm’s length standard (Art. 9 Para. 1
OECD-MT): transfer price = market price
 As market prices for international transactions rarely exist, MNCs have an
incentive to use the imprecision of transfer pricing to reduce overall tax burden
• Tax administrations are aware of profit shifting opportunities and impose
strict rules and extensive documentation requirements on the multinational
companies to limit their room for maneuver
 Companies’ cost of compliance with the tax law increases
Permanent Establishment
• Permanent establishment (PE) is a fixed place of business through which

the business is carried on
• The country where the PE is located is entitled to tax the profits attributed
to the permanent establishment (Art. 7 Para. 2 OECDMT)
• The company’s total profit must be attributed to the domestic and the
foreign part of the company respectively following the dealing at arm‘s-
length principle
• Because the foreign PE and the domestic parent company (the head office)
are an economic unit as well as a legal unit (in the sense that the PE is not
legally separate), it is impossible for the principal company to enter into
legal contracts with the foreign PE
• As opposed to legally separated subsidiaries, transfer prices stipulated in
legal contracts governing the internal transactions are non-existent
 Profit allocation through direct or indirect methods
Part III
Fundamentals of
Tax Planning

III.1 Cash Flow and Net Present Value
Tax Planning
• Tax planning
 Ex-post tax planning (tax minimization):
• After investment decision is made
• Reduce tax payments and increase after-tax cash flows
• Beneficial if additional net cash flow > additional cost
 Ex-ante tax planning:
• Before investment decision is made
• Impact on investment/financing decisions to increase after-tax cash flow
• International tax planning deals with
 Tax rates (vary across countries)
 Tax bases (tax-exemptions, expense deduction)
 Timing of tax payments (“paying taxes in the future is better than
paying taxes today”)
Net Present Value
• Profitability of real investments can be measured by the net

present value (NPV)
• Real investment is compared to an alternative financial
investment which yields the capital market interest rate
• The NPV is subject to several assumptions
 Existence of a perfect and unrestricted capital market
 Risk-free uniform interest rate for creditors and debtors
 Market interest rate denotes the yield of the capital market investment,
it indicates the market price for investing, lending or borrowing capital
(cost of capital)

Equity Financed Investments
• Net present value (without taxes)

𝑛𝑛
−𝑡𝑡
𝐶𝐶0 = −𝐼𝐼0 + 𝑃𝑃𝑉𝑉0 = −𝐼𝐼0 + � 𝐶𝐶𝐹𝐹𝑡𝑡 1 + 𝑖𝑖
𝑡𝑡=1
 NPV denotes the additional wealth generated by the real investment

which the investor can consume in 𝑡𝑡 = 0
 NPV = 0: no additional wealth by performing the (equity financed) real
investment compared to a capital market investment
 NPV > 0: profitable investment generates a higher return than the
alternative capital market investment
 NPV < 0: investment generates a lower return

• Influence of Taxes on NPV

1. Cash flow effect (numerator): taxes paid on profits reduce the
investment’s after-tax cash flow
• Profitability of real investment is reduced (exception: losses)
2. Depreciation effect (numerator): depreciation reduces taxable income
and thus tax liability
• Profitability of real investment is increased
3. Interest effect (denominator): taxes affect the yield of the capital
market investment
• If the financial investment is taxed, the interest rate has to be cut by the tax
rate applied to financial investments
• Profitability of capital market investment is reduced
 Taxes may also affect market prices (gross cash flows)
• Profit tax burden is shifted to market partners
86
• Assumption: gross cash flows are not affected
• Net present value after taxes

𝑛𝑛
𝐶𝐶0τ = −𝐼𝐼0 + 𝑃𝑃𝑃𝑃0τ = −𝐼𝐼0 + � (𝐶𝐶𝐹𝐹𝑡𝑡 − 𝑇𝑇𝑡𝑡 ) 1 + 𝑖𝑖τ −𝑡𝑡
𝑡𝑡=1
 Cash flow effect and depreciation effect (numerator):

• 𝑇𝑇𝑡𝑡 = τ𝑅𝑅𝐼𝐼 𝐶𝐶𝐹𝐹𝑡𝑡 − 𝐷𝐷𝑡𝑡
• Tax liability 𝑇𝑇𝑡𝑡 is the product of tax rate and tax base
• τ𝑅𝑅𝑅𝑅 denotes the proportional statutory tax rate which applies on profits of
the real investment
• 𝐷𝐷𝑡𝑡 denotes the depreciation of the investment outlay (accrual accounting:
tax base of income tax differs from the pre-tax cash flows)
• In case of a loss: 𝑇𝑇𝑡𝑡 < 0 (which implies an immediate tax refund)
 Interest effect (denominator):
• 𝑖𝑖τ = 𝑖𝑖(1 − τ𝐹𝐹𝐹𝐹 )
• τ𝐹𝐹𝐼𝐼 denotes the tax rate for financial investments
87
• Example III.1:
An individual investor invests 100 in an asset which has a useful life of two years
(straight-line depreciation). The investor faces an income tax rate of τ𝑅𝑅𝑅𝑅 = 45%.
The market interest rate amounts to 10%. The individual investor is subject to
personal income tax on financial investments at a uniform rate of τ𝐹𝐹𝐼𝐼 = 25%.
88
III.2 Investment Shifting and Profit Shifting
Relevant Tax Drivers in Transnational Investments
• Tax planning: make business choices that, net of taxes, increase the
investor’s wealth
• How to compare the tax burden of different choice alternatives?
• Example: Location of an investment project
1. Consider nominal tax burden
Subsidiary in country A Subsidiary in country B
40%
20%

• Concept of nominal tax burden

 Takes into account the cumulative marginal statutory tax rates of taxes
levied on an investment
 In case of corporate investments, relevant taxes cover the corporate
level and, if relevant, the shareholder level
 All relevant profit taxes (e.g. corporation tax, local profit taxes,
surcharges) are taken into account
 Respect is given to the interrelations between the different types of
taxes (e.g. resulting from the deductibility/creditability of one tax
from/against another tax)

Example:
Germany Malta
Pre-tax profit 100 100
Trade tax 14+ -
local trade tax multiplier of 400%

Corporation tax 15.83* 35.0
Nominal tax burden
29.83 35.0
(corporate level)
* Includes solidarity surcharge

Dividend 70.17 65.0
‡ Full imputation system

Taxable income 70.17 100.0
Tax credit --- 35.0
Income tax
+ Assumes
18.51 0.0‡
(26.375%* / 35%)
Nominal tax burden
48.33 35.0
(in total)
91
• Tax planning: Make business choices that, net of taxes, increase the
investor’s wealth
• How to compare the tax burden of different choice alternatives?
• Example: Location of an investment project
1. Consider nominal tax burden
2. What about the tax base?
Subsidiary in country A Subsidiary in country B

40%
20%
One-off Straight-line
depreciation depreciation
in 1st year over 10 years
• Example:
 Investment of 100 generates pre-tax cash flows of 110 in t = 1 and 60
in t = 2
 The MNC subsidiary in country A is taxed at a profit tax rate of 40%.
The investment outlay of 100 is immediately expensed (one-off
depreciation)
 The MNC subsidiary in country B is taxed at a profit tax rate of 40%
(case A), 39% (case B) or 38% (case C). The investment outlay of 100
is capitalized and depreciated straight-line over a period of two years
 The capital market interest rate is 10% (investment is realized in
country A; interest payments are taxed at a rate of 40%)
• Discount factor: 1 + 𝑖𝑖τ = 1 + 0.1 1 − 0.4 = 1.06
 Shareholder level should not be taken into account (e.g., investment
profits are retained and are not repatriated to the parent company)
NPV after taxes for subsidiary in country A (τ = 40%)

 Discount factor: 1 + 𝑖𝑖τ = 1 + 0.1 1 − 0.4 = 1.06
t 0 1 2
CFt -100 110 60
Depreciationt 100 0
Tax Baset 10 60
Taxt 4 24
𝐶𝐶𝐶𝐶𝑡𝑡τ -100 106 36
NPV (𝐶𝐶0τ ) 32.04

NPV after taxes for subsidiary in country B (case A: τ = 40%)

t 0 1 2
CFt -100 110 60
Depreciationt 50 50
Tax Baset 60 10
Taxt 24 4
𝐶𝐶𝐶𝐶𝑡𝑡τ -100 86 56
NPV (𝐶𝐶0τ ) 30.97

NPV after taxes for subsidiary in country B (case B: τ = 39%)

t 0 1 2
CFt -100 110 60
Depreciationt 50 50
Tax Baset 60 10
Taxt 23.4 3.9
𝐶𝐶𝐶𝐶𝑡𝑡τ -100 86.6 56.1
NPV (𝐶𝐶0τ ) 31.63

NPV after taxes for subsidiary in country B (case C: τ = 38%)

t 0 1 2
CFt -100 110 60
Depreciationt 50 50
Tax Baset 60 10
Taxt 22.8 3.8
𝐶𝐶𝐶𝐶𝑡𝑡τ -100 87.2 56.2
NPV (𝐶𝐶0τ ) 32.28

• Summary:
 Case A (τ𝐴𝐴 = 40%, τ𝐵𝐵 = 40%): location of the investment in country
A (𝐶𝐶0τ = 32.04) is preferred over location in country B (𝐶𝐶0τ = 30.98)
 Case B (τ𝐴𝐴 = 40%, τ𝐵𝐵 = 39%): location of the investment in country
A (𝐶𝐶0τ = 32.04) is preferred over location in country B (𝐶𝐶0τ = 31.63)
• Tax base effect and the associated timing effect are decisive
 Case C (τ𝐴𝐴 = 40%, τ𝐵𝐵 = 38%): location of the investment in country
B (𝐶𝐶0τ = 32.28) is preferred over location in country A (𝐶𝐶0τ = 32.04)
• Low profit tax rate works in favor of country B
• Tax rate effect is decisive

• Advantage of tax rate and tax base differentials across countries

• Incentive to invest in low-tax countries (real investment shifting)
 By shifting real investments to countries where profit taxes are low, a
multinational company may increase the company’s after-tax cash flow and
market value
• Incentive to engage in international acquisitions (cross-border acquisitions)
 By acquiring low-taxed companies, the multinational company’s profit tax
burden decreases and its market value increases
• Incentive to shift tax bases from high-tax to low-tax countries (profit
shifting by internal transactions)
 Examples:
• Subsidiary located in low-tax country delivering goods to an affiliated subsidiary
located in high-tax country charge a high transfer price
• Debt financing of subsidiaries located in high-tax countries by corporations located
in low-tax countries
European Tax Planning
• Europe is a challenging area for international tax planning as

there are remarkable differences in corporation tax rates across
European countries
 European countries compete for both real investments and income tax
bases by lowering their corporation tax rate
• European Directives address taxes charged on cross-border
dividends, interest and royalty payments, and are aimed at the
enhancement of the internal market
 Parent Subsidiary Directive, Interest and Royalties Directive
 Directives remove tax impediments on cross-border flows of
investment income
• PSD and IRD facilitate international tax planning because both directives
eliminate withholding taxes in the source country
Parent Subsidiary Directive (PSD)
• Purpose: elimination of double taxation on inter-corporate dividends

• PSD regulates that
1. Subsidiary’s country of residence may not levy a withholding tax on intra-EU dividends
(Art. 5 PSD)
2. Parent’s country of residence has to apply either the exemption or credit method for
incoming dividends (Art. 4 PSD)
• Deduction of management costs and interest payments related to shareholding can
be disallowed in parent’s country if the amount does not exceed 5% of the dividend
• Conditions:
 Entities are resident incorporated companies of a Member State subject to corporate tax
 Parent must hold at least 10% of the equity capital of the subsidiary
 Member States can require an uninterrupted holding period of a maximum of 2 years
• PSD ensures that profits earned by a subsidiary are only taxed once
 Because Member States usually exempt foreign dividends from the corporation tax base,
the dividends are only burdened with the foreign corporation tax on the profit
 Enables parent companies to take advantage of low foreign corporation taxes
101
Parent Subsidiary Directive (PSD)
Country A Country B
Border
Parent Subsidiary
profit is taxed in B
Dividend
dividend is taxed in A withholding tax on

dividend in B

Interest and Royalties Directive (IRD)
• Purpose: avoiding double taxation which may arise because the source country
levies a withholding tax on the gross income, while the country of residence
taxes the net profit
• IRD regulates that the source country may not levy a withholding tax on any
inter-corporate interest or royalty payments including payments from or to
permanent establishments (Art. 1 Para. 1 IRD)
• Interest: income from debt claims of any kind (whether or not carrying a right
to participate in the debtor’s profits)
• Royalties: payments from the use of intangible assets (e.g., copyrights, patents)
• Conditions:
 Entity must be incorporated in a Member State, has to be resident in a Member State
for tax purposes and has to be subject to corporation tax
 A company must hold at least 25% of the equity capital of another company (or a
third company must hold at least 25% of the capital of both companies)
 Member States can require an uninterrupted holding period of up to 2 years
103
Interest and Royalties Directive (IRD)
Country A Country B
royalty: 100
Border
Parent Subsidiary
20 % 20 %
expenses: 80
withholding tax:
100 x 20 % = 20
tax base: 100 – 80 = 20
tax = 4 with IRD:
tax base: 100-80 = 20
credit method: tax = 4 (no tax credit)
tax credit = 4 ⟹ total tax burden: 4 ⟹ 20 %
additional tax = 0
⟹ total tax burden: 20 ⟹ 100 % 104
III.3 Legal Restrictions on Tax Planning
Tax Planning versus Tax Fraud
• Tax planning (or tax avoidance): use legal rules to reduce taxes
• Tax planning opportunities can be explicitly or implicitly offered
 Explicit: accelerated instead of straight-line depreciation
 Implicit: choice between a foreign permanent establishment or a foreign
subsidiary, choice between financing with equity or with debt
• Tax planning is respected by the tax law as long as the taxpayers claim to
have economic reasons
 The courts rule in favor of the taxpayers if their decisions are not taken for the
sole purpose of avoiding taxes
 Consequently, taxpayers may arrange their business affairs to keep taxes low as
long as they comply with the law
• Taxpayers commit tax fraud if an action contradicts the law
 Examples: taxpayers do not disclose all relevant information, disclose wrong
information or falsify documents
 Tax fraud is punished by law 105
General Anti-Abuse Rules
• Aim: counteracting tax avoidance
• Tax law restricts tax planning opportunities if specific types of tax planning
are considered to be harmful to the national tax revenue
• General anti-abuse rules deny tax advantages if they
 have been achieved by implementing a tax planning strategy
 which is inappropriate in both legal and economic terms
 and serves the sole or main purpose of saving taxes
• Such general anti-abuse rules may not be applicable, if the taxpayers can
give significant non-tax reasons for having chosen this strategy
• Anti-abuse rules targeted at international tax planning exist virtually in all

countries
Specific Anti-abuse Rules
• Member States of the EU implemented a wide range of specific anti-abuse

rules in order to qualify certain tax planning strategies as undue tax
avoidance
• Common specific anti-abuse rules:
 Controlled Foreign Corporations Legislation
 Thin Capitalization Rules

Controlled Foreign Corporations (CFC) Legislation
• If CFC rules apply, the foreign corporation’s income is re-

classified as domestic income and included in the income of
the domestic shareholders
• Foreign income is subject to the shareholders’ domestic
income tax and foreign taxes may be credited
• Subsequent distribution of foreign income is usually not taxed
• Conditions in general:
1. Foreign corporation is controlled by a domestic resident who owns at
least 50% (sometimes 25%)
2. Foreign company is resident in a low-tax country
3. Foreign company earns passive income

Controlled Foreign Corporations (CFC) Legislation

Thin Capitalization (TC) Rules
• Target: excessive shareholder debt financing (internal debt)

 If TC rules apply, deduction of interest payments which relate to shareholder
debt financing is disallowed
 Double taxation can occur
• Conditions in general:
1. Creditor is a foreign shareholder who owns at least 25% (sometimes 50%) of
the equity capital
2. The debt-equity ratio is restricted (ratio of 3:1 or 4:1 is common)
• Italy and Germany extend the scope of TC rules to all kinds of debt
 Deductibility of interest expenses is limited to a certain percentage of an
earnings figure (interest stripping rule)
 Germany disallows the deduction of interest payments exceeding 30% of the
earnings before interest, taxes, depreciation and amortization (EBITDA)
 Excessive interest payments may be carried forward and deducted in following
years
Part IV
International
Corporate Tax Planning

IV.1 Tasks of International Corporate Tax Planning
International Tax Arbitrage
• Task: increase after-tax cash flows and the group’s market value
• International tax planning
 Aims at avoiding legal double taxation
 Focuses on tax arbitrage
• International tax arbitrage
 Cash flow and interest advantages by exploiting differences in taxes and tax
bases across countries
 Many forms of international tax arbitrage:
• Investment locations
• Legal form of foreign investments
• Acquisition of foreign companies
• Financing and profit distribution
• Allocation of ownership rights
• Structure of intra-group asset transfers
112
IV.1 Tasks of International Corporate Tax Planning
Restrictions and Frictions
• Legal restrictions reduce the room for maneuver of tax planning schemes
which aim at exploiting an international tax differential
• Specific tax rules reduce or even eliminate tax savings
 Group’s transfer prices
 Leverage
• International tax planning faces economic frictions: tax planning costs
 Direct cost: Fees for legal advice and the taxpayers cost to comply with the tax
law (e.g., preparing tax accounts and income tax statements)
 Indirect costs: tax efficient structures ≠ structures chosen in the absence of
taxes

IV.2 Investment Decisions
Overview
We will focus on:

• Permanent Establishment versus Subsidiary
• Investment Location
• Loss Compensation
• Transfer Pricing

Permanent Establishment versus Subsidiary
• Corporate investors have the choice between a

 Permanent establishment (legally not separated from the investor and pass-
through taxation applies)
 Subsidiary (distinct entity)
• Very often: When choosing between a foreign subsidiary and a foreign
permanent establishment, the profit taxes of the corporate investor are
almost irrelevant for this decision
• Permanent Establishment
 Source country where the permanent establishment is located has the right to
tax the income earned through (attributed to) the permanent establishment (Art.
5 and Art. 7 OECD-MT)
• Profits are subject to corporation tax in the source country (limited tax liability)
 Residence country of the corporation may have the right to tax business income
derived from the foreign permanent establishment (unlimited tax liability)
• Many double taxation treaties exempt such foreign profits from domestic taxation
• Subsidiary
 Foreign corporation is a separate legal entity subject to unlimited tax liability in the
foreign country
 If profits are distributed, both the source country (limited tax liability of the investor) and
the residence country (unlimited tax liability of the investor) are entitled to tax the
dividends
• Foreign withholding taxes burdened on dividends can be credited against the
domestic corporation’s tax liability
• Germany exempts inter-corporate dividends, but charges 5% of the dividends as
non-deductible business expenses to corporation tax and to local trade tax
• Within the EU, withholding taxes are limited by the PSD (inter-corporate dividends)
– Withholding taxes are disallowed in the source country
– Residence country of the corporate investors has to account for double
taxation by using either the exemption or the credit method (Classification of
5% of dividends as non-deductible business expenses is permitted)
– European corporate groups do not face withholding taxes on dividend income

Taxation at the shareholder’s level

• If the corporation distributes the foreign profits (i.e., dividends
from foreign subsidiary or the profits earned in foreign
permanent establishments), shareholders are taxed upon the
dividends received
• In Germany, dividends are either subject to
 a final withholding tax of 25% (shareholding is held as private asset) or
 60% of the dividend is taxed as ordinary income subject to the
progressive income tax rate schedule (i.e., 40% of the dividend is tax-
free if the shareholding is a business asset)

• Example IV.1:
G Corporation is located in the EU Member State G and wholly owned by an individual
who is resident in EU Member State G. G Corporation considers investing in Member State
F through a permanent establishment or through a wholly owned subsidiary which
immediately distributes its profits. G Corporations profits (cash flows) are taxed at τ𝐺𝐺 =
30%. The individual shareholder is taxed at τ𝐷𝐷 = 25% on dividend income. The
corporation tax rate in country F amounts to τ𝐹𝐹 = 25%. Country F levies a withholding
tax on dividends of 15% (according to the double tax treaty), but does not levy a
withholding tax if 10% of the equity is hold by the parent corporation (in accordance with
PSD). Country G exempts foreign profits as well as inter-corporate dividends, but taxes 5%
of the dividends as non-deductible business expense.

119
Investment Location
• Tax burden of an investment is determined by tax rate and tax base

• At first glance, a high tax rate seems to be unfavorable
• However, if the investment is tax-advantageous with respect to the tax base, high
statutory tax rate translates in high tax savings
 Examples: accelerated depreciation, immediate deduction of investment outlay
 Advantage of higher tax rates: higher tax savings, e.g., due to depreciation (𝐷𝐷𝑡𝑡 × 𝜏𝜏)
⟹ Advantage of higher tax rates remains constant if CF increases
• On the other hand, the higher the rate of return on the investment, the more
advantageous are low statutory tax rates
 Disadvantage of higher tax rates: CF is taxed at a higher level ⟹ Disadvantage of higher
tax rates increases if CF increases
• The positive effect of a favorable tax base remains constant irrespective of the
profitability, whereas the negative effect of a high statutory tax rate on profits
becomes more important when taxable profits rise
• Many countries have followed a tax policy of tax-rate-cut-cum-base-broadening in
the past
Investment Location
• Marginal Investments
 Investors who already invest in different locations face the choice of where to
locate additional investments
• Example IV.2:
G Corporation is resident in country G. G invests equity capital of 100 in a self-created
intangible asset (development costs). G is considering investing either in country G or in
the foreign country F via a permanent establishment. In both countries, the same pre-tax
cash flows are expected. The capital market interest rate is 𝑖𝑖 = 10%. G is subject to limited
tax liability in country F and taxed at a corporation tax rate of τ𝐹𝐹 = 20%. In country F, the
investment outlay is capitalized and depreciated straight-line over a period of two years,
whereas in country G the investment outlay is immediately expensed. If the investment is
located in country G, G as a taxpayer with unlimited tax liability faces a corporation tax
rate of τ𝐶𝐶 = 40%. An immediate loss offset is available. The foreign business income is
tax-exempt in country G. Individual income taxes are ignored (τ𝐹𝐹𝐹𝐹 = 0%, 𝑖𝑖τ = 10%).

Investment Location
Country F

Investment Location
Country G

Investment Location
• Summary
 Country G in effect grants a tax deduction on the investment outlay
 Tax savings related to the investment outlay are front-loaded
 Positive timing effect generated by the tax base outweighs the negative
tax rate effect
 Marginal investment is better off in tax terms if located in country G

Investment Location
• Profitable Investments
 Investors who face the decision where to locate a profitable investment
primarily react to differences in statutory tax rates
 Consider the investment in Example (3.2), but assume that the pre-tax cash
flows are higher, which renders the investment profitable before taxes
• Example IV.3:
The assumptions of Example (IV.2) apply. However, the pre-tax cash flow amounts to 90 and
82.50 in t = 1 and t = 2, respectively.
• Summary
 Location of the investment in country F is now preferred
 Tax rate effect is decisive, whereas the tax base is of minor importance
 The higher tax rate hits the positive (pre-tax) NPV while the timing effect
caused by the tax base remains unchanged
 Conclusion: Location decisions on profitable investments are driven by
differences in the location’s statutory tax rate
Investment Location
Country F

Investment Location
Country G

Loss Compensation
• Tax-deductibility of losses: investor receives a tax benefit

when losses are incurred
 Benefit increases the investment’s cash flow and NPV
• Loss carry-forward:
 Losses can only be deducted from future profits
 Future tax savings are generated leading to positive effects on the
investments cash flow (cash flow effect)
 Problem: investor suffers from negative timing effects, reducing the
investments’ NPV (timing effect)
 In a cross border setting, both effects depend on the loss offset rules of
source and residence country

Loss Compensation – Cash Flow Effect
• Accrual accounting: tax losses ≠ negative cash flows

 Negative tax base may occur because tax depreciation exceeds
revenues (cash inflows)
• Corporation carrying out an additional investment is able to
offset losses with profits from other activities
 Tax savings should be allocated to this investment
• Immediate tax deduction increases investment’s after-tax cash
flow and NPV
• Loss carry-back may also result in an immediate tax refund
 Loss carry-back is often not available or is restricted
• Example IV.6:
C Corporation invests 100 in an asset with a useful life of two years. C
Corporation is in an overall profit situation and is taxed at 30%. Net cash
flows are discounted at the net interest rate 𝑖𝑖τ = 7%.
129

Without loss offset provision

• Foreign permanent establishment

 Under the residence principle, foreign loss is included in company´s
worldwide income  Immediate and unrestricted loss offset is available if
the parent company is in an overall profit position
 However, if foreign profits are exempted, foreign losses are also excluded
• Foreign subsidiary
 Losses do not reduce the parent company’s taxable income
 Losses have to be accounted for in subsidiary’s residence country
 Pooling foreign losses with domestic profits or domestic losses with
foreign profits is impossible
• Foreign retained profits are shielded from the domestic base
• Foreign inter-corporate dividends are tax-free and not available for loss offset
 Given the restrictions on loss transfer, foreign as well as domestic losses
may be final, resulting in negative cash flow effects
132
Loss Compensation – Timing Effect
• Loss carry-forward
 Losses are deducted from profits in subsequent years
 Usually restricted by time and by amount
 Restrictions on loss offset entail negative timing effects
• Loss carry-forward negatively affects NPV of investments because tax
savings from loss deduction are deferred
 Example IV.7:
A subsidiary resident in country F faces a corporation tax rate of τ𝐹𝐹 = 19%.
The investment outlay of 60 is depreciated over three years on a straight-line
basis. The loss carry-forward is restricted to five years. In each year a
maximum of 50% of the initial loss is tax-deductible if the subsidiary generates
sufficient profits. The subsidiary discounts its cash flows at an interest rate of
𝑖𝑖τ = 10%.

Immediate loss offset

• Loss carry-forward reduce profitability of an investment

 Negative interest/timing effect
 If losses cannot be offset: Negative cash flow effect
• Immediate loss deduction: foreign loss is accounted for in the
residence country and investors are in an overall profit
situation
• If the foreign loss is excluded from domestic income, the loss
may only be carried forward in the foreign country
 Investors who expect losses will prefer foreign countries which do not
restrict the loss carry forward

Transfer Pricing: Subsidiary
• Incentive to shift taxable profits to low-taxed subsidiaries via

transfer pricing
• A precise determination of transfer prices is often not possible
• Room for tax planning
 Manipulating transfer prices can reduce the group’s overall tax burden
 Investment location decisions and profit shifting through transfer prices
are interrelated
 Corporation may invest in a high tax country through a subsidiary if it
is able to shift the profits out of the high-tax country to a low-taxed
subsidiary
 Profit shifting increases the investment’s NPV in the high-tax country

• Statutory tax rate

 International tax planning through transfer pricing is driven by the statutory
tax rate
 One euro of shifted profit saves an amount of taxes
 Tax saving is determined by the difference between the statutory profit tax
rates of the two corporations involved in profit shifting
 The more profit is shifted to a low-taxed foreign subsidiary, the more the
overall tax burden approaches the foreign corporation tax rate
• Example IV.8:
G Corporation, resident in country G, delivers 1,000 units of goods (production cost of
90) to the affiliated S Corporation, resident in country S, at a stipulated price (transfer
price) of 100 per unit. S Corporation sells the good to a third party at a price of 130
per unit. G Corporation and S Corporation are subject to corporation tax at a rate of
30% and 20%, respectively. Three cases are compared:
(i) Both countries consider the transfer price of 100 to be at arm’s length,
(ii) Both countries consider the transfer price of 100 not be at arm’s length and
adjust it to 125,
(iii) Country G adjusts the transfer price to 125, whereas country S assumes the
transfer price of 100 to be at arm’s length.
138
139
• Summary
 Case 1:
• 75% of overall profit is allocated to the low-tax country S
• Overall tax burden is close to the corporation tax rate of country S
 Case 2:
• 87.5% of overall profit is allocated to high-tax country G
• Overall tax burden is close to the corporation tax rate in country G
 Case 3:
• Tax bases overlap and double taxation arises
• Profit of 25,000 is allocated to both countries and the aggregated tax base
amounts to 65,000
• Overall tax burden is above the corporation tax rate in country G

Restrictions
• Tax law restricts contracts which are not at arm’s length
Frictions
• Functions of transfer pricing
 Transfer pricing is used for internal coordination and internal profit
allocation
 Tax planning is another dimension of transfer pricing
 Companies may use two separate sets of transfer prices
• Problem: two sets of transfer prices may adversely affect the acceptance of the
company´s transfer price system within the company
• Tax compliance costs
 Additional costs arise from documentation obligations
 Tax compliance costs increase in frequency and in complexity of intra-
group transactions Prof. Dr. Martin Fochmann 141
Transfer Pricing: Permanent Establishment – Exemption Method
• OECD approach: permanent establishment is treated as a

functionally separate and independent enterprise
 Dealings between the principal company and the permanent
establishment are determined by assessing transfer prices which are
used in case of legally separated entities (i.e. corporations)
 MNC has again some room for tax planning
• The economic effects of shifting profit to a foreign permanent
establishment depend on the method of avoiding double
taxation
• Exemption Method
 If the principal company’s country of residence applies the exemption
method, the tax burden in the (foreign) source country is final
 The more profit is taxed in the source country, the closer the overall tax
burden comes to that country’s corporation tax rate
• Example IV.9:
G Corporation is resident in country G and delivers 1,000 units of goods
(production cost of 95) to a permanent establishment in country S at a transfer
price of 100 per unit. The permanent establishment sells the good to a third
party at a price of 125 per unit. The pre-tax profit per unit amounts to 125 –
95 = 30, which translates in an overall pre-tax profit of 30,000. G
Corporation is subject to corporation tax at a rate of 30%. The permanent
establishment’s profits are taxed at a rate of 20% in country S (limited tax
liability).Three cases are compared:
(i) Both countries consider the transfer price of 100 to be at arm’s length,
(ii) Both countries consider the transfer price of 100 not to be at arm’s
length and adjust it to 120,
(iii) Country G adjusts the transfer price to 120, whereas country S assumes
the transfer price of 100 to be at arm’s length. Country G exempts
profits generated by foreign permanent establishments
144
Transfer Pricing: Permanent Establishment – Credit Method
• Credit Method
 Country of residence includes foreign profits in the taxable income of
the principal company
 Foreign profits are taxed at the rate of the parent company
 Foreign income tax is credited against the income tax of the parent
company
• Example IV.10:
See example IV.9. Country G taxes the worldwide income and grants a
foreign tax credit.

1,500
7,500
20% � (5)
12,500
17,500
41.67 146
Tax credit is limited to

• amount of taxes paid in foreign country
(i) (ii) (iii)
5,000 1,000 5,000
• amount of domestic tax due on the foreign income

 foreign income is determined according to domestic law
(i) (ii) (iii)
125 − 100 × 1,000 125 − 120 × 1,000 125 − 120 × 1,000

⟹ 25,000 × 30% ⟹ 5,000 × 30% ⟹ 5,000 × 30%
= 7,500 = 1,500 = 1,500

Transfer Pricing: Permanent Establishment
• Exemption method
 Strong incentive to shift profits to low-taxed foreign permanent
establishments
• Credit method
 Principal company does not have an incentive to shift profits to a low-
tax country
 If countries agree on the arm’s length transfer price, only the tax rate of
the principal company matters
• Restrictions
 No legal restrictions since there is no legal contract
 But: profits attributed to a foreign permanent establishment have to
conform to the arm’s length principle

IV.3 Financing Decisions
Overview
We will focus on:

• Internal Debt
• External Debt
• Profit Repatriation

Internal Debt
• Parent company can finance an investment of a foreign

subsidiary by
 contributing equity capital to the foreign subsidiary (new
equity financing)
 granting a loan (internal debt)
• Tax Asymmetries
 Cost of debt capital is tax-deductible
• Civil law obliges the debtor to pay interest on the loan and grants the
creditor a claim to the interest payments
 Cost of equity capital is not tax-deductible
• Civil law grants the owner of equity capital a residual claim to the net cash
flows
 Profits are in principle taxed where they are generated (source
principle) whereas interest income is taxed where the recipient of
interest payments is resident (residence principle)
Internal Debt – Economic Effects
• Equity financing
 Foreign subsidiary is burdened with foreign corporation tax (unlimited
tax liability)
 Distributed profits may be subject to foreign withholding taxes
• Within the EU: Parent Subsidiary Directive
 Dividends received by the domestic parent company are usually tax-
free if the parent company is a corporation
 Profits distributed by the corporate parent to natural persons (as
ultimate shareholders) are usually taxed under a shareholder relief
system
 Tax burden of equity financed investments is determined by
• foreign profit taxes and
• both foreign and domestic taxes upon the distribution of profits

Internal Debt – Economic Effects
• Debt financing
 Interest payments on loans are tax-deductible by foreign corporation
 Interest income is taxed when received by domestic company granting
the loan
 Foreign country may levy a withholding tax on interest payments
(limited tax liability of the creditor)
• Within the EU: Interest and Royalties Directive
 Withholding taxes are creditable against corporation tax on the interest
income received if a corporation grants the loan
 Tax burden is exclusively determined by the corporation tax of the
corporation granting the internal loan
• Requirements: no restrictions on interest deductibility and withholding
taxes are fully credited

Internal Debt – Tax Shield
• Debt financing generates a tax shield because tax-deductible

interest payments reduce corporation tax
• Assumption: interest payments (of the amount 𝐼𝐼 = 𝑟𝑟𝐿𝐿𝑡𝑡 ) of a
corporation to its shareholders permanently substitute the same
amount of profit
𝑟𝑟𝑟𝑟 τ𝐷𝐷 − τ𝐼𝐼 + 1 − τ𝐷𝐷 τ𝐶𝐶
𝑇𝑇𝑇𝑇 =
𝑖𝑖τ
τ𝐷𝐷 : dividend tax rate τ𝐼𝐼 : interest income tax rate
τ𝐶𝐶 : corporation tax rate 𝑖𝑖τ : after-tax market interest rate
 τ𝐷𝐷 − τ𝐼𝐼 : income tax rate effect of switching from equity to debt
 1 − τ𝐷𝐷 τ𝐶𝐶 : corporation tax savings considering dividend taxation
• If τ𝐷𝐷 = τ𝐼𝐼 and tax payments are discounted at the market

interest rate (𝑖𝑖τ = 𝑟𝑟), tax shield reduces to 𝑇𝑇𝑇𝑇 = 𝐿𝐿 1 − τ𝐷𝐷 τ𝐶𝐶
153
Internal Debt – Tax Shield – Proof
Equity Debt
Profit 𝑃𝑃 𝑃𝑃
Interests - 𝑟𝑟 × 𝐿𝐿
Tax Base 𝑃𝑃 𝑃𝑃 − 𝑟𝑟 × 𝐿𝐿
Tax 𝜏𝜏𝐶𝐶 × 𝑃𝑃 𝜏𝜏𝐶𝐶 × (𝑃𝑃 − 𝑟𝑟 × 𝐿𝐿)
Pre-tax Dividend 𝑃𝑃 × (1 − 𝜏𝜏𝐶𝐶 ) (𝑃𝑃 − 𝑟𝑟 × 𝐿𝐿) × (1 − 𝜏𝜏𝐶𝐶 )
Dividend tax 𝑃𝑃 × (1 − 𝜏𝜏𝐶𝐶 ) × 𝜏𝜏𝐷𝐷 (𝑃𝑃 − 𝑟𝑟 × 𝐿𝐿) × (1 − 𝜏𝜏𝐶𝐶 ) × 𝜏𝜏𝐷𝐷
After-tax Dividend 𝑃𝑃 × (1 − 𝜏𝜏𝐶𝐶 ) × (1 − 𝜏𝜏𝐷𝐷 ) (𝑃𝑃 − 𝑟𝑟 × 𝐿𝐿) × (1 − 𝜏𝜏𝐶𝐶 )
× (1 − 𝜏𝜏𝐷𝐷 )
Interest income - 𝑟𝑟 × 𝐿𝐿
Tax on interests - 𝑟𝑟 × 𝐿𝐿 × 𝜏𝜏𝐼𝐼
After-tax interests - 𝑟𝑟 × 𝐿𝐿 × (1 − 𝜏𝜏𝐼𝐼 )
Difference: (𝑃𝑃 − 𝑟𝑟 × 𝐿𝐿) × (1 − 𝜏𝜏𝐶𝐶 ) × (1 − 𝜏𝜏𝐷𝐷 ) + 𝑟𝑟 × 𝐿𝐿 × (1 − 𝜏𝜏𝐼𝐼 ) −
𝑃𝑃 × (1 − 𝜏𝜏𝐶𝐶 ) × (1 − 𝜏𝜏𝐷𝐷 ) = 𝑟𝑟 × 𝐿𝐿 × (𝜏𝜏𝐷𝐷 − 𝜏𝜏𝐼𝐼 + (1 − 𝜏𝜏𝐷𝐷 )× 𝜏𝜏𝐶𝐶 )
154
Internal Debt – Tax Shield – Proof
𝑇𝑇𝑇𝑇𝑖𝑖𝑖𝑖 𝑜𝑜𝑜𝑜𝑜𝑜 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝 = 𝑟𝑟𝑟𝑟(𝜏𝜏𝐷𝐷 − 𝜏𝜏𝐼𝐼 + (1 − 𝜏𝜏𝐷𝐷 ) × 𝜏𝜏𝐶𝐶 )
𝑇𝑇𝑇𝑇𝑖𝑖𝑖𝑖 𝑜𝑜𝑜𝑜𝑜𝑜 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝

𝑃𝑃𝑃𝑃𝑇𝑇𝑇𝑇 = ∑𝑛𝑛𝑡𝑡=1
(1+𝑖𝑖𝜏𝜏 )𝑡𝑡
If TS occurs in each period: perpetual annuity!
𝑇𝑇𝑇𝑇𝑖𝑖𝑖𝑖 𝑜𝑜𝑜𝑜𝑜𝑜 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝

𝑛𝑛 −> ∞ ⟹ 𝑃𝑃𝑃𝑃𝑇𝑇𝑇𝑇 =
𝑖𝑖𝜏𝜏

• Assumptions:
 Shareholders of the corporate parent are ignored
 Tax exemption of inter-corporate dividends (τ𝐷𝐷 = 0)
 Tax payments are discounted at the market interest rate (𝑖𝑖τ = 𝑟𝑟)
• Tax shield of a domestic corporate parent created by an internal loan
which is granted by the parent to a foreign subsidiary:
𝑇𝑇𝑇𝑇 = 𝐿𝐿 −τ𝐶𝐶𝐶𝐶 + τ𝐶𝐶𝐹𝐹
with τ𝐶𝐶𝐶𝐶 = τ𝐼𝐼 and τ𝐶𝐶𝐶𝐶 = τ𝐶𝐶
• Under these conditions:
 It is tax efficient for the domestic parent to finance a foreign subsidiary
with internal debt if the subsidiary is located in a high tax country (τ𝐶𝐶𝐶𝐶 <
τ𝐶𝐶𝐶𝐶 )
 If the foreign subsidiary’s tax rate is lower than the parent’s tax rate (τ𝐶𝐶𝐶𝐶 >
τ𝐶𝐶𝐶𝐶 ) the tax shield is negative and the parent will prefer equity financing to
debt financing 156
• Example IV.13:
H Corporation, resident in country H, wholly owns F Corporation, a
subsidiary located in country F. H Corporation is considering an investment
of 100 perpetually yielding a pre-tax return of 20%. H Corporation evaluates
whether to finance the investment in country F with new equity or with an
internal loan at 10%. The corporation tax rates of H Corporation and of F
Corporation amount to 10% and 30%, respectively. Withholding tax is not
levied upon the distribution of F Corporation’s profits. H Corporation receives
dividends tax-free. The after-tax market interest rate amounts to 10%.
.

158
Internal Debt – Thin Capitalization Rules
• Many countries have introduced thin capitalization (TC) rules to

combat profit shifting through debt financing
• Internal loans are less attractive if interest payments of the
subsidiary receiving the loan are fully or partly non-deductible
expenses
• Germany:
 German TC rule restricts interest deductibility to 30% of the corporation’s
EBITDA (stripping rule)
 Stripping rule applies to all business under following conditions:
• Interest expenses exceeding interest income exceed three million euro
• Business belongs to a group
• Leverage of group company is higher than the group’s total leverage
 Non-deductible interest expenses can be deducted in subsequent years
(interest carry forward)
• Non-deductible interest expenses are not ultimately lost
• But: taxpayers suffer from a negative timing effect 159
Internal Debt – Thin Capitalization Rules
• Example IV.14:
Consider again example (IV.13) and assume that F Corporation faces a TC rule of
the German type. In this case, interest expenses are tax-deductible up to 30% of
the EBITDA.
Ignoring depreciation and amortization, tax-deductible interest expenses amount
to 6 (= 30% · 20) resulting in a taxable profit of 14 (= 20 – 6) and corporation tax
of 4.20 (= 30% · 14). F Corporation’s profit distribution is reduced to 5.80. If the
interest income of H Corporation is fully taxed, H Corporation’s profit distribution
is reduced to 14.80 (= 10 + 5.80 – 1.00) which translates to an NPV of the debt
financed investment of 48. The reduction in NPV by 12 reflects the increase in F
Corporations income tax of 1.20 (= 4.20 – 3.00). Nevertheless H Corporation will
still prefer debt financing to equity financing.
Note: F Corporation’s actual interest expenses of 10 always exceed the tax deductible
amount of 6. As a result, the interest carry-forward increases over time but can never
be used by F Corporation in this example.
. Prof. Dr. Martin Fochmann 160
External Debt
• In many countries interest expenses related to foreign investments

may be tax-deductible, even though the profits they generate are not
taxed in the same country
 Domestic corporation take up a loan and transfer the proceeds of the loan
as an equity contribution to a foreign subsidiary
 Interest expenses are tax-deductible, whereas profits of a foreign subsidiary
are not taxed in the domestic country until distributed
 Distribution is (often) tax-free for domestic corporation
• Tax Arbitrage
 Asymmetric taxation offers strong incentives to engage in international tax
rate arbitrage
 Idea:
• Refinancing equity contributions to low-taxed foreign subsidiaries with
external debt
• Interest payments save taxes in a high-tax country
• Profits related to the respective capital are taxed in low-tax country
161
External Debt – Tax Arbitrage
• Domestic corporation takes up a loan at the market interest rate r

• Corporation invests the proceeds in an equity contribution to a
foreign subsidiary
• Subsidiary invests the capital at a pre-tax rate of return of p and is
taxed at the corporation tax rate τ𝐶𝐶𝐶𝐶
• Tax savings related to interest expenses deducted by domestic
corporation: τ𝐶𝐶𝐶𝐶
• Investment’s after-tax return amounts to
𝑝𝑝 1 − τ𝐶𝐶𝐶𝐶 − 𝑟𝑟 1 − τ𝐶𝐶𝐻𝐻
• Opportunity for tax rate arbitrage if τ𝐶𝐶𝐶𝐶 < τ𝐶𝐶𝐻𝐻
• Assuming p = r:
𝑝𝑝 τ𝐶𝐶𝐶𝐶 − τ𝐶𝐶𝐶𝐶 > 0
• Corporation can generate tax savings on investments with a pre-tax
profit of zero (i.e., p – r = 0)
162
External Debt – Thin Capitalization Rules
• TC rules are usually targeted at internal debt

• Some countries extend their TC rules to cover external debt
 German TC rules, for example, apply to all kinds of debt financing
• TC rule: interest payments are not tax-deductible and do not
immediately generate tax savings
• Example IV.15:
A German parent corporation establishes a wholly owned subsidiary in country F
with an equity contribution of 100. The subsidiary yields a perpetual profit of 10.
The German corporation takes up a loan of 100 at an interest rate of 10% to
refinance the equity contribution. The German parent corporation has sufficient
profits to absorb the interest expenses. The corporation tax in country F amounts
to 10%. The German trade tax rate amounts to 14% and the German corporation
tax rate amounts to 15.83% (including solidarity surcharge) respectively. Upon
profit distribution, the German parent has to pay taxes on 5% of the dividends
received. Withholding taxes are not levied by Country F.
For trade tax purposes, Germany allows a deduction of 75% of the interest
expenses only. 163
External Debt – Thin Capitalization Rules
164
Profit Repatriation
• Retained profits of a foreign subsidiary

 Not taxed until shareholder receive them
 Ability to defer income taxes on foreign profits
 The longer profits are retained, the less pronounced is the income tax
burden on dividend distributions in present value terms
• Irrelevance of dividend taxation
 Decision to retain does not depend on shareholder’s dividend tax (since
shareholders are unable to avoid income taxes)
 Profit retention if foreign > domestic after-tax rate of return (𝑖𝑖τ,𝐶𝐶𝐶𝐶 > 𝑖𝑖τ )
 Formally:
• Foreign profit can be distributed as dividend DIV either at t = 0 or at t = n
• Tax advantage of profit retention: Δ𝐶𝐶𝐹𝐹𝑛𝑛 (at t = n)
𝑛𝑛 𝑛𝑛
Δ𝐶𝐶𝐹𝐹𝑛𝑛 = 𝐷𝐷𝐷𝐷𝐷𝐷 1 − τ𝐷𝐷 1 + 𝑖𝑖τ,𝐶𝐶𝐶𝐶 − 1 + 𝑖𝑖τ
𝑖𝑖τ,𝐶𝐶𝐶𝐶 : foreign corporation’s after-tax rate of return of capital market investment
𝑖𝑖τ : domestic shareholder’s after-tax rate of return of capital market investment 165
Profit Repatriation
Immediate distribution (repatriation in t = 0):

𝑛𝑛
𝐶𝐶𝐹𝐹𝑛𝑛 = 𝐷𝐷𝐷𝐷𝐷𝐷 1 − 𝜏𝜏𝐷𝐷 × 1 + 𝑖𝑖𝜏𝜏
Profit retention (repatriation in t = n):

𝑛𝑛
𝐶𝐶𝐹𝐹𝑛𝑛 = 𝐷𝐷𝐷𝐷𝐷𝐷 1 + 𝑖𝑖𝜏𝜏,𝐶𝐶𝐶𝐶 × 1 − 𝜏𝜏𝐷𝐷
𝑖𝑖𝜏𝜏,𝐶𝐶𝐶𝐶 > 𝑖𝑖𝜏𝜏  profit retention preferred
if 𝑖𝑖𝐹𝐹 = 𝑖𝑖𝐷𝐷 : 𝑖𝑖 1 − 𝜏𝜏𝐶𝐶𝐶𝐶 > 𝑖𝑖 1 − 𝜏𝜏𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷

 if 𝜏𝜏𝐶𝐶𝐶𝐶 < 𝜏𝜏𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷 : profit retention preferred
𝜏𝜏𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷 : domestic shareholder’s tax rate for capital market investment

Profit Repatriation
• Example IV.16:
G Corporation holds 100% of the shares of foreign F Corporation. F
Corporation has retained profits of 100 which can be reinvested at the
pre-tax rate of return of 10%. The foreign corporation tax rate is 10%. G
Corporation’s profits tax rate is 30%; dividends received are taxed at
1.5%. At time t = 3, G Corporation compares the cash flow of repatriation
at time t = 3 and at time t = 0. G Corporation’s shareholders are
neglected. If G Corporation repatriates the foreign profits at t = 0,
corporate tax on dividends is paid at t = 0. The after-tax profit distribution
is invested at the after-tax market interest rate of 7% (= 10% x ( 1 – 0.3)).
Alternatively, G Corporation defers the repatriation of the foreign profits
to time t = 3.

Profit Repatriation
Repatriation in t = 0

Profit Repatriation
Repatriation in t = 3

Profit Repatriation – Controlled Foreign Corporations (CFC) Legislation
• Idea: incentive to accumulate capital in foreign low-taxed

corporations is reduced
• Shareholders’ country of residence will often implement CFC rules
• If CFC rules apply, the foreign corporate profit is included in the
current taxable income of the shareholders
 CFC rule is only applied for passive income
 Not taxed under dividend taxation scheme
 Shareholders’ domestic income tax rate applies to the foreign income
 Lower foreign corporation tax rate is no longer effective
 Subsequent profit distributions are usually tax-free (as the distributed
profits have already been taxed when allocated to the shareholders)
 Conclusion: CFC rules reduce the after-tax rate of return of the foreign
investment to that of a domestic investment
• Example IV.17:
The assumptions of Example (IV.16) apply. F Corporation has retained
earnings which can be seen active income. Under the CFC rules of G
Corporations residence country, F Corporation’s profits derived from the
reinvestment of retained earnings of 100 at the capital market are included
in G Corporation’s taxable income and taxed at a rate of 30%. Foreign
corporation taxes are credited against the income tax liability of G
Corporation.
F Corporation distributes profits up to an amount necessary to cover the
taxes of G Corporation.
Note: The CFC rules only applies for the profits derived from the
reinvestment of retained earnings! If retained profits (from active income)
are distributed, this is a dividend payment and no CFC income.
172
IV.4 Special Purpose Entities
Finance Companies
• Special purposes to improve MNC’s overall tax position

• Common strategy: interposing finance companies to use tax
asymmetries between equity and debt financing
• Typical structure of a finance company scheme is as follows:
 Finance company is located in a country with low tax rates or favorable
tax rules for finance companies
• Examples: Belgium, Ireland, Luxembourg, the Netherlands
 Finance company is funded with equity capital by the high-taxed parent
company
 Finance company forwards its equity capital to subsidiaries in high-tax
countries by granting loans

Finance Companies
Without finance company
Border
Parent Subsidiary
company
(Germany) dividend of 75 (tax-free) (Denmark)
30% 25%
Profit = 100
-> tax = 25

Finance Companies
With finance company

Profit = 100
tax = 10
Finance
dividend of 90 Company
(tax-free) 10% 100 interest payments (i = 10%)
equity loan
1000 1000
Parent Subsidiary
company
(Germany) (Denmark)
30% 25%
Profit = 100
- 100
-> tax = 0
Finance Companies
• Economic Effects
 Earnings of foreign subsidiaries are transferred as tax-deductible interest
payments to finance company
 Corresponding interest income is subject to low corporation tax
 Repatriation of the finance companies’ profits to the ultimate parent
company does not trigger additional taxes in general
 Conclusion: foreign profits are taxed at the low corporation tax rate of the
finance company’s country
• Effects on tax revenues
 Subsidiary’s country suffers from a loss in corporation tax revenue from
the tax-deductible interest expenses
 Parent company’s country forgoes corporation tax revenue because taxable
interest income is channeled through the finance company and thus
transformed into tax-free dividend income
 Finance company’s country increases its tax revenue because it attracts
finance companies
Finance Companies – Restrictions
• Success of such tax planning strategy depends on

 TC rules in country where debt financed subsidiary is located (source country) and
 CFC rules in country where the finance company’s shareholder is resident (residence
country)
• Source country applies TC rules
 Deductibility of interest payments is restricted
 Group may face double taxation
• Income taxes are charged on the non-deductible amount of interest payments
• Finance company’s country of residence levies income taxes on the interest payments
• Shareholder’s residence country applies CFC rules
 Parent company is taxed on profits of finance company at regular tax rates
 Corporation taxes of the finance company may or may not be credited against the income
taxes of the parent company

Finance Companies – Restrictions
• Some EU Member States exclude subsidiaries located in other

EU Member States from the application of CFC and TC rules
 Finance company can use its low-taxed profits to grant new loans to
high-taxed affiliates or distribute the low-taxed profits to parent
company
• No withholding tax for EU intra-group interest payments
 Finance company receives interest income free of foreign taxes
• No withholding tax for EU intra-group (corporate) dividends
 Corporate parent generally does not pay taxes on the dividends
received
 If repatriation of finance company’s profits is tax-free, parent company
is able to invest low-taxed foreign profits at home or abroad

Holding Companies
• Parent company can

 directly hold the shares of a foreign company or
 interpose a foreign holding company which owns the shares of foreign
company
• Holdings can be interposed to use foreign group taxation regimes
• Group taxation regimes are usually restricted to resident companies
 Establishing a tax group in foreign country: shareholdings in the foreign
subsidiaries are transferred to a foreign holding company which in
exchange issues new shares (generally: share exchange is tax-free)
 Example IV.19:
G Corporation owns 100% of the shares of FP Corporation and FL
Corporation both located in country F. G Corporation establishes FH
Corporation as a holding company in country F to acquire the shares of
FL Corporation and FP Corporation in exchange for its own shares. After
the transaction is completed, G Corporation directly owns the shares of
FH Corporation and, thus, indirectly owns the shares of FL Corporation
and FP Corporation. 179
Holding Companies – Loss Compensation Strategy
• Foreign subsidiary is unable to transfer a loss to its parent

company or to another affiliate
• Holding companies enable the compensation of losses
 Parent company is in a position to consolidate foreign subsidiary’s
losses with profits of other foreign subsidiaries resident in the same
country
 Example IV.20:
G Corporation owns 100% of the shares of FP Corporation and FL
Corporation both located in country F. While FP Corporation earns
profits in the amount of 500, FL Corporation suffers from a loss in the
amount of 400 in the same year.
G Corporation establishes the holding company FH Corporation.

G G
20 % 100 % 100 % 100 %

FP FL 20 % FH
taxable income: 100
500 -400 -> tax: 20 Tax
tax: 100 tax: 0 100 % 100 % Group
FP FL
500 - 400
total tax: 100
100 %
total profit: 100 => 20/100 = 20 %

G G
20 % 100 % 100 % 100 %

FP FL 20 % FH
taxable income: 100
500 -400 => tax: 20 Tax
tax: 100 tax: 0 100 % 100 % Group
FP FL
500 -400
total tax: 100
100 %
total profit: 100 => 20/100 = 20 %

Holding Companies – Acquisition Strategy
• Acquisition of foreign company with a share deal

 Acquiring corporation will usually take up a loan to finance acquisition
 After acquisition: target corporation may distribute its profits to finance the
corresponding interest expenses
 Inter-corporate profit distributions are tax-free
 Acquiring company may not be able to deduct the interest expenses
• To achieve consolidation of the interest expenses with profits of
target company, acquiring corporation interposes a holding company
 Holding company is granted a loan by the acquiring corporation and buys
the shares in the target company
 Holding and target company can take advantage of a group taxation regime
• Profit of target company is attributed to holding company
• Holding company is able to absorb the interest expenses with taxable profits of
target company
30 %
loan acquiring 100 % target

BANK
corporation corporation
Interests - 100 profit: 100

- 30
70

30 %
loan acquiring 100 % target

BANK
corporation corporation
Interests - 100 profit: 100

- 30
70
tax group
loan acquiring loan 100 %
BANK Holding target
corporation
Interests
- 100 Interests - 100 100
+ 100 Interests
0 taxable
income: 0

Holding Companies – Debt Strategy
• Acquisition holding companies can be used to accumulate debt

in high-tax countries via internal share deals
 First step: a corporation sells the shares in an affiliated corporation (the
target company) located in a high-tax country to a locally resident
holding company
• Transaction takes place at the market value of the shares, but gains upon
the sale of shares are generally tax-free for a corporation
 Second step: holding company takes up a loan
• Holding and target company form a tax group enabling the holding
company to deduct the interest expenses from the taxable profits of the
target company

Parent 100 % Subsidiary

25% 35%

Parent 100 % Subsidiary

25% 35%
35% tax group
Parent 100 % 100 %

Holding Subsidiary
25%

• The holding company may take up either an internal loan or an

external loan
 External loan:
• MNC increases the amount of debt allocated to the high tax country
• Interest tax shield is created
 Internal loan:
• Loan is granted to the high-taxed holding company by a low-tax country
finance company, ensuring that the corresponding interest income is low-
taxed
• Group transfers taxable profits from a high-tax country through interest
payments to a low-tax country
 In both cases, the group is able to accumulate additional debt in a high-
tax country (without affecting the target company’s leverage)

Profit = 100
tax = 10
Finance
Company
dividend of 90 10%
(tax-free)
equity 100
1000 interest
loan payments
1000 (i = 10%)
35% tax group
Parent 100 % Holding 100 % Subsidiary

25% -100 100
tax: 0

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Tax Effects

Prof. Dr. Martin Fochmann

Prof. Dr. Martin Fochmann 2

• Taxes have a negative impact on economic activities

→ Therefore tax planning is a major part of corporate

Prof. Dr. Martin Fochmann 3

• Net Present Value before taxes:

Prof. Dr. Martin Fochmann 4

• Net Present Value after taxes:

→ If taxes are not considered, investment decision is biased! 5

• Earnings Per Share (EPS) as a key indicator of a company’s

• Taxes directly reduce net income and therefore have a great

Prof. Dr. Martin Fochmann 6

• The MNC shows the following financial key data:

• Earnings Per Share = EUR 70 Mio / 20 Mio = EUR 3.50

Prof. Dr. Martin Fochmann 7

• Goal: increase EPS by EUR 0.25 to EUR 3.75 (= 7.14 %)

Prof. Dr. Martin Fochmann 8

• Economics, business in particular, is about making

Source: Endres and Spengel (2015), p. 23.

Prof. Dr. Martin Fochmann 10

• In an international context, the importance of taxation

• International tax planning aims at taking advantage

Prof. Dr. Martin Fochmann 11

• Section 3 of the German Fiscal Code (Abgabenordnung):

Prof. Dr. Martin Fochmann 12

Prof. Dr. Martin Fochmann 13

no deduction: 30,000 × 30 % = 9,000

• Personal income tax is payable by all individuals in a country

Prof. Dr. Martin Fochmann 15

• Idea: given the same conditions and circumstances, people

• Example with two periods

T(50,000) = 12,500 (25%)

Sportsman income 100,000 0

Prof. Dr. Martin Fochmann 17

• Idea: given different conditions and circumstances, people

• Ability-to-pay principle: people should be taxed according to

Prof. Dr. Martin Fochmann 19

• Ability-to-pay and net principle are generally valid for a

• Sum of cash flows after taxes: 50

• Sum of cash flows after taxes: 75

Prof. Dr. Martin Fochmann 23

• Sum of cash flows after taxes: 75

• Tax refund due to carry-back in t = 2:

• Tax refund due to carry-back in t = 2:

Source: Endres and Spengel (2015), p. 18.

Prof. Dr. Martin Fochmann 27

Prof. Dr. Martin Fochmann 28

Prof. Dr. Martin Fochmann 29

Prof. Dr. Martin Fochmann 30

Prof. Dr. Martin Fochmann 31

• Tax collection can be in the form of

Tax Evasion Tax Avoidance

• Any action by the

International Tax Planning

Substantive Tax Planning Formal Tax Planning

• Economic activity is changed • A given structure of economic

Prof. Dr. Martin Fochmann 34