In this article, we are going to discuss what is inbound and outbound cross-border taxation. We will go through both categories one by one explaining with the help of straightforward examples.
We begin by examining multinationals based in a home country that invest at home or abroad. To keep things simple, multinationals finance subsidiary investments through origin equity transfers, inter-corporate debt transfers, or third-party borrowing. According to transfer price rules, the interest cost for inter-corporate and third-party debt for the subsidiary is considered the same. Nevertheless, equity transfers are financed by the origin through equity and debt raised to invest in their subsidiary or domestic investments.
Cross-border Tax provisions are relevant to taxing capital in the host country and the tax savings from interest deductions taken by the origin when calculating effective tax rates on capital. Therefore, the effective tax rate reflects both the subsidiary’s tax plans and its host tax provisions. In this regard, debt financing is entirely reliant on arbitrage. Take the case of an Irish parent investing in Canada. Taxes on income earned from the Irish investment are 12.5 percent. There is, however, a 31.7 percent deduction for interest expenses in Canada.
Ireland’s lower effective cross-border tax rate can be achieved through international arbitrage by transferring debt to Canada rather than Ireland. To determine the tax rate on capital, debt placement should be considered. For the past ten years, it has been assumed that 25 percent of parent equity transfers are financed by debt and 75 percent by subsidiary equity transfers. The origin company is financed by 40 percent debt and 60 percent equity, consistent with typical Canadian debt-asset ratios.
This means that the original company and the subsidiary company jointly finance $55 percent of the investment with debt (25 percent in the host country and 30 percent indirectly through the parent company).
Inbound Cross Border Taxation
Inbound capital expenses are typically limited in many countries. In Canada, for example, the rule that prohibits a deduction for interest expense exceeding two times equity applicable to shares and debt held by related parties in Canadian subsidiaries is known as the thin capitalization rule.
The Australian government also limits interest deductions to no more than 75 percent of domestic assets, excluding credit card debt and accounts payable to third parties. Interest expense is deductible in the United Kingdom only if it meets the commercial test. According to income stripping rules in the United States. In Germany, for example, deductions are limited to a percentage of earnings before interest, taxes, depreciation, and amortization are deducted.
Outbound CrossBorder Taxation
Multinational corporations are often required to allocate interest expenses based on their investments domestically and abroad if they make outbound investments. The United States uses this approach in general, while Australia uses it for its inbound and outbound investment thin capitalization approach.
We have examined in depth the cross-border taxation investments under international corporate taxation implementation. Corporate taxes have a significant impact on international business decision-making, as we conclude in this article. Since no country can control other countries, it is difficult to establish an equal playing field for domestic and cross-border investments. We hope that this article helps you understand cross-border taxation in a more profound manner. If you think you still have some questions regarding this topic you can contact us.
Sohail Afzal, CPA, CMA, MBA
Sohail Afzal, (CPA, CMA, MBA) is the founder & CEO of GTA Accounting Professional Corporation. He is a highly experienced Chartered Professional Accountant and businessman himself and understands the challenges that many businesses face when it comes to cash flow management. As an experienced business consultant & tax advisor, he is helping companies grow by providing the technical, financial, and contractual information necessary for strategic decision-making.