TAXATION OF INTERNATIONAL INVESTMENT FLOWS

International Taxation with Neutral Effect on Investment Decisions

Practical Foreign Tax Crediting Issues

Flow-Through of Foreign Tax Credits: Foreign Investment Case Study

Integrating Taxable Income of Entities in the International Scene

How to tax income from investments while minimising the impact on investment decisions has been discussed in relation to income from assets/liabilities either held directly by individuals or held by entities with individuals as beneficiaries or owners. In the discussion, the assets/liabilities, the direct individual investor, the entities and their individual beneficiaries/owners have largely been assumed to be in the same country.

How is this discussion affected by the introduction of the possibility of investment offshore by local individuals or entities, with that investment made either directly in offshore assets/liabilities or in offshore entities (which, in turn, potentially hold assets/liabilities, including other entities, in any country or countries)?

In short, the international dimension of the taxation of income from investments does not add any new conceptual issues to the discussion. As with the introduction of entities, the neat neutrality property illustrated in Figure 2 need not change just because cash flows returning from offshore investments are reduced by foreign tax payments. With the benchmark tax base applying to the local assessment of offshore investments, pre-tax returns of 10% across alternative offshore investments, for example, will be reduced to 5.3% for local taxpayers on a 47% local tax rate if, after their local tax assessment, their local tax payable plus foreign tax paid is still 47% of taxable income.

In practice, there are a number of circumstances where total (foreign plus domestic) tax paid on domestic taxable income of offshore investments matches the local taxpayer's marginal tax rate:

• if the rate of foreign tax on the taxable income (as assessed locally, ignoring foreign taxes paid) is less than the taxpayer's tax rate and the local tax authority provides a full credit off local tax for the foreign tax paid - foreign tax credit systems (FTCS), common around the world, can provide this outcome for high taxing countries;

• if the rate of foreign tax on the taxable income (as assessed locally, ignoring foreign taxes paid) is the same as the taxpayer's tax rate and the local tax authority exempts that taxable income from tax - exemption arrangements (either general exemptions for foreign income or exemptions in relation to income from specified countries, say, based on the tax systems and tax rates of those countries) are also common but the required outcome is strictly only achieved when the foreign and domestic rates of tax are the same; and

• if the rate of foreign tax on the taxable income (as assessed locally, ignoring foreign taxes paid) is greater than the taxpayer's tax rate and the local tax authority not only provides a full credit off local tax for the foreign tax paid but also provides a refund for the excess foreign tax paid over the tax assessed locally.
  • Not surprisingly, governments are not inclined to provide such refunds which would effectively result in foreign treasuries gaining at the expense of the local treasury.
  • Nevertheless, conceptually at least, neutrality of foreign investment decisions could be achieved by low taxing countries operating with the benchmark tax base through this type of refund.

Thus, with the benchmark tax base and FTCS applying everywhere and with low taxing countries providing refunds for excess foreign taxes over local taxes on income from foreign investments, neutrality of foreign investment decisions could theoretically be achieved universally regardless of tax rates applying in particular countries. And individual countries do not have to wait for other countries to achieve tax neutrality of foreign investment decisions made by its residents. Figure 14 illustrates how a higher taxing country (A) with a benchmark income tax base (plus entity taxation sympathetic to that benchmark) and a FTCS can achieve tax neutrality of decisions by its residents to invest in lower taxing countries (B).

This highlights the importance to the achievement of tax neutral decision making of foreign tax crediting arrangements. Foreign tax crediting arrangements, however, raise a raft of practical administrative and compliance issues. The international dimension might not add new conceptual issues but it certainly adds an array of significant practical issues.

To achieve neutrality of the local investor's investment decisions the answer to all of these questions would need to be 'Yes'. In addition, as noted, refunds of any excess foreign over local tax would need to be provided by the local tax authorities - requiring the foreign taxes paid (net of any refunds provided) to be clearly identified by foreign taxing authorities, including all the foreign taxes paid on conduit income.

Some of these practical foreign tax crediting questions - those relating to the flow-through of foreign tax credits to local individuals investing offshore via local entities and to 'conduit' income flows - are presented in Figure 15.

The issues raised in Figure 15 can be analysed by studying the cash flows of hypothetical investment projects. The practical foreign tax crediting issues can then be seen in a way that helps consideration of tax policy options along with associated implications for administration and compliance and the drafting of associated law.

• an appreciating asset (land), with a 10% pre-tax return, acquired in Year 0 for $1000, that increases in value by 10% a year - foreign tax is paid at 20% on all the realised gain on the land when IntCo sells it in Year 5; and

• a depreciating asset, also with a 10% pa pre-tax return and again acquired in Year 0 for $1000, but being a horticultural plant (perhaps a vineyard or orchard) does not produce net receipts until Year 3. Its value therefore increases (at 10% pa) as access to the net receipts gets closer and then declines at 15% a year (reflecting declining annual net receipts) - foreign tax is paid each year on the income of the asset with tax depreciation allowed from Year 3 at 15% pa.

In Year 2, IntCo acquires 100% of an offshore company (OffCo), requiring John to contribute a further $2420 of capital. Since Year 0, OffCo has owned two assets with identical physical and tax characteristics as those of IntCo, including each having a 10% pa pre-tax return:

• an appreciating asset (land) - OffCo includes all of the realised gain on the sale of the land in Year 10 in its taxable income; and

• a depreciating asset (horticultural plants, like a vineyard, orchard, etc, with a delay before first net receipts) - OffCo includes in its tax assessments the net receipts from this asset plus 15% reducing balance depreciation allowances.

IntCo pays local company tax at 30% again under a full imputation system. John's marginal tax is 47%. IntCo sells its ownership of OffCo before IntCo liquidates in Year 5. OffCo continues operating with its two assets through the change of ownership in Year 2 (bought by IntCo) and Year 5 (sold by IntCo) and finally sells its assets and liquidates in Year 10.

The tax laws in both IntCo's and OffCo's countries have general CGT arrangements that mean 100% of realised gains and losses on the buying and selling of company shareholdings (and other CGT assets like land) are included in tax assessments and impose 15% DWT on unfranked dividends paid to non-residents.

The structure of John's offshore investment via IntCo is illustrated in Figure 16. If any 'owners', or shareholders, of IntCo were non-residents, distributions from IntCo to them would represent 'conduit' flows from the offshore country of OffCo and the offshore country of IntCo's directly held foreign assets via IntCo to the non-resident shareholders' countries. If non-resident shareholders of IntCo were residents of OffCo's country, the flows from OffCo via Intco and back to IntCo's shareholders in OffCo's country illustrate the 'triangular' conduit case.

The after-tax cash flow stream that John realises from his investment via IntCo depends importantly on the foreign tax crediting arrangements that apply in John's home country - both those arrangements that apply to IntCo when it receives its offshore non-dividend and dividend income and those that apply to John himself when that income flows out of IntCo to him. It turns out that the shape of these crediting arrangements and the tax treatment of dividends flowing from IntCo to non-resident shareholders also have a big part to play in the degree of complexity of the associated law and of administration and compliance. A small change to the policy design of foreign tax crediting arrangements can have large impact on legal and administrative complexity.

The hypothetical example will initially be looked at in the presence of full imputation company taxation and FTCS arrangements (as opposed to exemption), under three alternative policy options: 'simplicity', 'complexity' and 'compromise'. The cash flows of OffCo, shown in Figure 17, are the same under each of the three policy options. A total of $925 of tax is paid by OffCo and its shareholders to its local tax authority - comprising company tax, personal income tax by OffCo's local shareholders (all of whom are on 47% tax rate) before and after IntCo owns the company and DWT paid on unfranked dividends repatriated to IntCo in Years 3 to 5.

Simplicity. Administrative/compliance issues and tax law drafting are much simplified if the policy mix is to have: (1) all foreign taxes on IntCo's offshore income (dividend and non-dividend) credited against IntCo's domestic tax on that income; (2) those credits flow through to IntCo's individual shareholders, like John; and (3) no domestic tax (eg DWT) paid on any taxable offshore income distributed to non-resident shareholders (conduit income) beyond any 'top up' domestic tax paid by IntCo on this income.

Accompanying FTCS arrangements 'top up' the foreign tax paid on IntCo's offshore taxable income with local tax payable by IntCo, with both the foreign and local taxes then able to be attached to dividends paid to IntCo's shareholders. The FTCS arrangements also afford the simplicity of a single mechanism - which ideally would also apply to direct offshore investments by local individuals - for adding all IntCo's gross-of-tax foreign taxable income (regardless of source and type of income) for determining local tax payable after providing credits for foreign taxes. If, instead of FTCS, IntCo were exempt from local tax on its offshore income, the zero local tax payable on that income would be appropriate if the rate of foreign tax on that income happened to match the company tax rate in IntCo's country - but dividends out of that income (net of foreign taxes) would be unfranked, attracting double tax in the form of DWT (absent special arrangements) when going to non-residents and the tax rates of local individual shareholders when going to them.

The full imputation system itself already provides the required standard legal and administrative arrangements for this 'Simplicity' policy set for foreign tax crediting. All that is required to achieve the policy set is for the foreign taxes paid on the offshore income to be added, along with domestic taxes paid, to IntCo's franking credit account. Those credits then flow through to IntCo's individual domestic shareholders (perhaps through a chain of domestic companies) when dividends are paid. In addition, as all taxable offshore income would be franked (either by foreign or domestic taxes) no DWT would be payable on that income if it were distributed to non-resident shareholders - though annual income distributed that is not in taxable income would still be unfranked and subject to DWT (though not if integration of taxable income were superimposed on imputation arrangements with no separate identification of unfranked dividends). The policy set - particularly the flow-through of credits for foreign taxes to individual domestic shareholders - may have significant tax revenue implications but the extra demands beyond those of full imputation in terms of complexity of the law, administration and compliance would be minimal. This hypothetical situation corresponds to that depicted in Example 15 in the set of Kyscope Examples.

Figures 18 and 19 show the cash flows of IntCo and its local shareholders under this approach to foreign tax crediting policy. Original shareholders like John remain shareholders throughout IntCo's five years of operation and IntCo distributes to shareholders in Year 3 and in the year of liquidation. Any effect on the cash flows of currency exchange rate movements is ignored. Some analysis of foreign investment decision-making in the presence of currency exchange rate changes is undertaken in the Financial Assets and Liabilities paper.

Figure 19 shows the return to IntCo's local individual shareholders (like John) on 47% tax rates to be 5.5% per annum over the 5 years of their investment. All IntCo's underlying assets over that time (the foreign assets both held directly and those held indirectly through OffCo) make 10% pa pre-tax returns. The 5.5% after-tax outcome only differs from the neutral benchmark 5.3% outcome (10% reduced by shareholders' 47% tax rate) mainly due to the effect under full imputation of retained income and no sales of shares by IntCo's shareholders. Had IntCo distributed available cash each year and IntCo's shareholders sold out each year to other local people, the return each year to shareholders selling out would be the benchmark 5.3%, consistent with the neutrality outcome illustrated in Figure 14 (and the same outcome under full imputation with distributions and sales of interests each year in Table 1 in Taxation of Entities paper).

This neutral outcome results from the full flow-through of foreign tax credits to IntCo's individual shareholders achieved simply by adding foreign taxes paid on IntCo's offshore investments to IntCo's imputation franking account.

Most notable in Figures 18 and 19 are the numerous ledgers that are not used under this policy mix despite alternating years of retention and distribution of cash by IntCo. The unrequired ledgers point to simplicity of associated law, administration and compliance. Those ledgers would be required to accommodate a variety of possible ways of responding to foreign tax crediting - like the 'Complexity' policy - that fall short of the 'Simplicity' policy mix and thus are unable to be implemented via the existing imputation franking account.

Under this 'Simplicity' policy mix, any non-resident shareholders of IntCo who are in the same country as OffCo (the 'triangular' case) would not need to complain that OffCo's franking credits are lost when OffCo's dividends pass through IntCo to them. Their dividend statements would show franking credits reflecting not only tax paid by IntCo in its country but tax paid elsewhere (including OffCo's country). They would, however, have to convince their tax authorities to allow all those credits to flow through OffCo to them as they see happening in IntCo's country.

The outcome in Figure 19 is consistent with neutral investment decision-making within the constraints imposed by full imputation in the circumstances depicted. This outcome would be expected to be accompanied by a single layer of foreign plus domestic tax at 47% on all the income of IntCo's and Offco's assets between capitalisation and liquidation. Both companies' individual shareholders are on 47% tax rates and the only non-resident dividend flows are from OffCo to IntCo. In addition, the question of refunds relating to any excess of IntCo's foreign tax credits over local tax on foreign taxable income is not an issue. The foreign tax rates (company tax rate for dividends and withholding rate on non-dividend income) in the source countries are 20% on franked dividends and non-dividend income and 15% on unfranked dividends, all lower than IntCo's 30% company tax rate.

One layer of tax at the rate of 47% is indeed confirmed by the flows in Figures 17, 18 and 19 and the above asset specifications (which determine total underlying income):

• The total income produced by the assets is $3562 (the sum of income in the asset specifications, including the $40 of interest income from IntCo's bank account).

• A single layer of tax at 47% on this income would yield $1674 tax.

• Tax paid in the hypothetical example comprises $925 by OffCo in its country (the company tax, personal tax plus DWT in Figure 17), $226 of foreign tax on IntCo's directly-held offshore assets, $202 of local company tax by IntCo (Figure 18) and $320 local personal tax after full foreign tax credit flow-through (Figure 19). The total is $1674 (with no rounding) confirming the required single layer of tax paid.

Complexity. If any of part of the 'Simplicity' policy set was unacceptable - most likely for tax revenue reasons - legal, administrative and compliance costs would increase. If, for example, the flow-through of foreign tax credits to individual domestic shareholders was considered unacceptable because of the potential cost to tax revenue, foreign taxes could not be added to imputation franking accounts. Thus, foreign dividends (net of foreign taxes) received by a domestic company that are repatriated to non-resident shareholders would be unfranked dividends and subject to DWT regardless of how much foreign tax had already been taken out of the foreign dividends received. Special accounting arrangements would have to be established to fulfil the policy requirement that offshore income of domestic companies would not be subject to additional domestic DWT when distributed to non-resident shareholders. A summary of such special arrangements in Australia relating to foreign dividends prior to the Review of Business Taxation (1999) is as follows:

• Special arrangements apply to offshore 'non-portfolio' dividends (reflecting a major shareholding) paid to Australian companies.
• Offshore non-portfolio dividends from 'listed' countries (those with tax rates comparable with Australia's) attract exemption, and so foreign dividend accounts (FDAs) are used to provide relief from DWT when Australian companies receiving offshore non-portfolio dividends pay these dividends as unfranked dividends to non-resident shareholders.
• Offshore non-portfolio dividends from unlisted company are subject to FTCS arrangements, and so relief from DWT is provided for the dividend income not subject to Australian company tax because of crediting of foreign tax paid on the dividends (the dividend income that is subject to Australian company tax is franked and so not subject to DWT).
• Offshore portfolio dividends (or other foreign source income) repatriated to non-resident shareholders do not attract any DWT relief.

Such special arrangements designed to ensure that non-resident shareholders are not subject to double tax on foreign conduit income highlight the inequity of doing that, on the one hand, and subjecting to double tax unfranked dividends paid to domestic individual shareholders out of foreign income, on the other.

Our hypothetical example may be used to illustrate complexities arising from varying the policy mix associated with the 'Simplicity' approach. Assume this time that tax authorities in IntCo's country agree to foreign tax credits flowing to local shareholders but not to DWT relief for non-resident shareholders. The imputation franking account again cannot be used as it can in the 'Simplicity' approach because franked dividends repatriated to non-residents do not attract DWT. Thus, a series of accounts/ledgers have to be used to handle the flow-through of foreign tax credits to local shareholders recognising that in some years IntCo will retain cash and in others full cash distributions may occur.

The correct use of the series of ledgers produces the same outcome for local shareholders as the 'Simplicity' approach. The same $522 overall tax revenue is paid by IntCo and its shareholders but all the extra ledgers required mean extra administrative and compliance costs.

Compromise. A compromise policy approach would draw on existing imputation arrangements with associated efficiencies as does the 'Simplicity' approach but would allow tax authorities to set operational parameters to restrict the cost to revenue as much as desired. This approach therefore accepts the three elements of the 'Simplicity' policy mix - but with watered down tax relief from each element (though full crediting or even exemption could be maintained at the entity level).

Only a specified amount of foreign taxes paid on domestic companies' foreign source income would be added to their imputation franking accounts. The same approach could be taken with individuals' direct offshore investments. All foreign taxes paid on foreign income could still be used with FTCS arrangements in determining domestic tax payable by companies on their offshore income (or exemption could apply). Alternatively, the reduced amount of credits to be included in franking accounts could be used in companies' FTCS arrangements. This alternative would mean the limitation on companies' foreign tax credits would be felt first at the company level. Ultimately, under full imputation, the same aggregate increased amount of tax would be collected but more of it would initially be paid by the company. In either case, however, the reduced amount of foreign taxes added to franking accounts would be determined on the basis of acceptable tax revenue outcomes.

There are a number of ways of effecting a reduction in foreign tax credits added to companies' franking accounts. One way is to specify acceptable rates of tax applicable to dividend and non-dividend offshore taxable income, measured locally. This would reduce credits going to the franking account on income from high taxing countries and potentially allow full crediting on income from very low taxing countries (countries with rates at or below the 'acceptable' rates).

This method of reducing foreign credits going to franking accounts is used with the hypothetical IntCo example to illustrate the 'Compromise' approach. In addition, all foreign taxes paid on IntCo's offshore income are fed into FTCS arrangements (so that the above alternative of reducing the amount of foreign taxes used in FTCS is not applied). Thus, IntCo's local tax payments ($202 in total) and its cash flows remain as in Figure 18. The foreign taxes added to IntCo's franking account are, however, reduced to 5% of both taxable dividend income and taxable non-dividend income (which is less than the 20% or 15% foreign tax applying to IntCo's foreign income).

Figure 20 shows the shareholder end of the hypothetical example with restricted amounts of foreign taxes added to IntCo's franking account.

With the flow-through of foreign tax credits limited in this way, the overall amount of local tax paid by IntCo and John the shareholder increases from $522 to $744. John's after-tax return reduces from 5.5% to 4.3%. (With no flow-through at all of foreign tax credits - a common situation globally - local tax would increase to $820 and John's return would decrease to 3.9%.)

Note, however, that the array of ledgers required under the 'Complexity' approach is not required under this 'Compromise' approach. While the flow-through of credits for foreign taxes on IntCo's offshore income is limited, the flow-through is still effected through the use of existing imputation arrangements. Simplicity is maintained while increased domestic tax revenue is achieved. Nevertheless, the greater the limitation on inclusion of foreign taxes in the franking account under the 'Compromise' approach, the higher the proportion of unfranked dividends associated with foreign income - and, thus, the greater the pressure for complex administrative arrangements to remove double tax on conduit foreign income. The trade-off between tax revenue and simplicity is not an easy one but the 'Compromise' example might help highlight some of the issues involved in that trade-off.

The regime of entity taxation involving integration of taxable income - with an imputation system still applying - fits neatly with arrangements which allow flow-through to entity owners/beneficiaries of credits for some or all of the foreign taxes paid on an entity's offshore income. Overlaying integration on imputation arrangements allows the flow-through to be achieved with all the administrative/compliance advantages of the 'Simplicity' approach - by adding some or all foreign taxes paid on an entity's income to the entity's franking account. For the entity's local owners/beneficiaries, the taxable income that is attributed to them each year regardless of whether the entity actually makes a distribution has attached credits for both local and foreign tax paid on that income. There is no need to distinguish for tax purposes unfranked dividends and returns of capital paid to local owners/beneficiaries (while distributed untaxed profits are not included in interest holders' assessments, the total amount of a distribution reduces tax values of entity interests).

For non-resident owners/beneficiaries, DWT would not payable at all if unfranked dividends were not specifically identified. Alternatively, if the abolition of DWT raised tax revenue concerns, either the tax base could be broadened sufficiently or DWT could still be payable on the 'unfranked' component of separate income measurement (retained from full imputation) to distinguish untaxed 'income' from returns of capital.

Figure 21 shows the shareholder end of the hypothetical example with integration of taxable income with all local and foreign taxes added to imputation franking accounts. The cash flows of IntCo itself are as in Figure 18. In addition, because all foreign taxes on IntCo's offshore dividend and non-dividend income are included in IntCo's local taxable income, all these foreign taxes form part of the annual tax value adjustments of IntCo's entity interests.

As in Figure 19, even though taxable income is attributed to owners/beneficiaries each year, $522 of local tax is paid by IntCo and its individual owners/beneficiaries - consistent with a single layer of (foreign and domestic) tax being paid at 47% on the income from all IntCo's assets. The return to individual owners/beneficiaries, at 5.5%, is higher than the benchmark 5.3% outcome as economic income in the early years of IntCo's operations (notably accrued capital gains on both the ownership of OffCo and IntCo's directly held assets) is not included in taxable income. Had IntCo's owners/beneficiaries sold out each year to other local people, the return each year would be the benchmark 5.3%, consistent with the neutrality outcome illustrated in Figure 14 (and the same outcome under integration of taxable income with sales of interests each year in Table 1 in Taxation of Entities paper).

Were economic income integrated, rather than taxable income, again $522 of local tax would be paid but the return to John, even if he retains his interest in IntCo over its five years of operation, would be the benchmark 5.3% pa - reduced from the 10% pa pre-tax return of all IntCo's foreign assets by John's 47% tax rate.

Figure 21 shows how domestic owners/beneficiaries of IntCo would get credits for foreign and domestic tax shown on dividend statements under integration of taxable income incorporating full flow-through of foreign tax credits. For non-resident owner/beneficiaries, too, details provided on dividend statements would show foreign tax payments relevant for purposes of foreign tax crediting arrangements available in their home countries. These foreign taxes would be those of the country running the integration system plus taxes imposed by other countries on conduit income flowing through IntCo's country - raising the question whether non-residents' countries would not only credit their residents for foreign taxes of a country running an integration system with foreign tax flow-through but also for those of other countries further up the payments chain. The dividend statement may also show unfranked dividend amounts on which DWT was payable (if a separate measure of income was used to distinguish between untaxed income and returns of capital). Should a non-resident's home country also be running full integration of taxable income, all the required details for assessment, crediting and tax value adjustments would be on the dividend statement.

Thus, overlaying integration of taxable income on full imputation arrangements neatly lends itself to the flow-through of foreign tax crediting. Nevertheless, such an entity tax regime could equally well co-exist with arrangements with limited flow-through like those of the 'Compromise' approach or those with a piece-meal approach to double tax relief on foreign income like the 'Complexity' approach. As with domestic full imputation arrangements per se, integrating taxable income in the presence of full imputation can accommodate whatever degree of complexity is required to provide tailored relief from double tax on foreign income.

Version 1.0 © Copyright Wayne Mayo 2009