Taxable base & rate: intercompany dividends & capital gains

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From the course by Universiteit Leiden

Rethinking International Tax Law

516 ratings

Universiteit Leiden

Rethinking International Tax Law

516 ratings

In recent years, the international tax planning strategies of multinationals have become a source of – often heated – debate. This course provides learners with the tools to become fully informed participants in the debate by explaining the foundations and practice of international tax law as well as addressing current developments and the ethical aspects of tax planning.

From the lesson

Design of corporate tax law systems

In this second module, we will start breaking down our tax planning base case. To that end, we will study the design of corporate tax law systems during this module. In the videos and (recommended) reading materials, we analyse the typical design elements of corporate tax law systems.

Taxable base & rate: intercompany dividends & capital gains4:41

Meet the Instructors

Prof. Dr. Sjoerd Douma
Faculty of Law
International Tax Center

Hi.

This is the fourth video lecture of this module,

in which we discuss the foundations of corporate tax law.

In this video, we will be looking at how countries deal with a specific type of

income which is received or derived from its shareholding and subsidiaries.

In the previous video, we noted that the corporate income tax which companies pay

is a percentage of that company's net income, the taxable base.

Typically, such net income can also include, for

example, dividends received from a subsidiary.

Where that subsidiary distributes its profits to it's parent company, or

capital gains or losses derived from the sale of the shares in subsidiaries.

A problem arises, however, with respect to corporate taxation, when a corporation

receives income, dividends or capital, from an investment in its subsidiary.

The problem is best demonstrated based on a numerical example.

Say, parent company receives a dividend from Sub, and Sub pays this dividend to

Parent Co from the profit it has made during that year of 1,000.

In line with the corporate income tax rules of the country in which it is

established, Sub already paid corporate income tax on those profits at a 25% rate,

in this case.

If the dividends are taxed again at Parent Co level,

effectively the profits generated by Sub will be taxed twice.

Resulting, in this case, on an effective tax rate on that income of 43.75%.

This problem, which is often referred to as cascading of tax through a chain of

companies, increases even more if the chain includes additional entities.

The problem of cascading of corporate tax through a chain of companies is

also referred to as economic double taxation in corporate tax structures.

In this respect, the term economic double taxation refers to the taxation of two or

more different entities, often by the same country, with respect to the same income.

To solve this problem, corporate income tax systems generally provide relief for

inter-company dividends.

In general, there are two main ways to avoid this double and

possible multiple taxation.

First, to exempt the income from taxation at the level of Parent Co.

This is referred to as a participation exemption.

Or second, to grant a tax credit for

taxes already paid by Sub, often referred to as an imputation system.

Practices and techniques in this respect, vary greatly between jurisdictions.

For example, also regarding the treatments of capital gains and sale.

As an example, if a parent company is established in the Netherlands,

the company can benefit from an exemption of dividends and

capital gains if it holds at least 5% of the nominal paid-up capital

of the subsidiary and passes one of three tests.

Looking again at our tax planning base case, we can see that from a corporate

income tax planning perspective, it is important, in particular, to establish

Intermediate Sub 1, in a jurisdiction which has an effective regime for

preventing double tax on dividends and capital gains in a structure.

In particular, in relation to income derived from local Sub.

Also, I would like to note, that the mechanisms for

avoidance of economic double taxation, can create an opportunity, for

further reduction of corporate income taxes.

Such opportunity might present itself where country B and country D qualify

funds provided by Intermediate Sub one to local Sub differently.

To illustrate, if we return again to our tax planning base case,

say Intermediate Sub one would provide funds to local Sub.

And, if country B qualifies such funds as capital investments,

any return on that investment would likely be non-taxable,

based on the local mechanism for avoidance of economical double taxation.

If country D qualifies the investment as a loan under it's domestic tax rules,

any return paid on that investment will be considered interest.

And, as we saw in video two in this module,

such interest payment would reduce taxable base of Local Sub.

Different interpretation of the qualification of an investment, debt or

equity is called a hybrid mismatch.

We will look at hybrid mismatches in more detail in Module 3.

In this video,

we've learned how countries effectively prevent economic double taxation.

In the next video,

we will examine rules that typically apply in relation to corporate groups.

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