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Unit 14: Management Control of MNC’s

source income derived from a minority foreign subsidiary is normally taxed to the parent Notes
company only when remitted to the parental through the dividend route. A foreign subsidiary
in which the parent owns more than 50% of voting equity is a controlled corporation. Active
foreign source income from a controlled foreign subsidiary is taxed only as remitted to the
parent but passive income whether to be taxed or not depends upon the tax laws of the parent
home country.

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Caution The management of an MNC must be aware of any differences in the taxation of
income by a particular host country when deciding whether to organise a foreign operation
as a branch or subsidiary.

Example: New foreign affiliates experience operating losses in the early years of
operation. In such a situation, it may be beneficial for the MNC to organise overseas operations
initially, as a foreign branch of the parent because branch’s operating losses are consolidated
with the parent company’s earnings for tax purposes.
In a situation where foreign source income is to be re-invested abroad to expand foreign
operations, it may be preferable to organise it as a minority foreign subsidiary if the foreign
income tax is less than the home country of the parent because the tax liability of the parent can
be deferred until the subsidiary remits dividend to the parent.

Task Japanese MNCs such as Toyota, Toshiba and Matsushita made extensive investment
in South East Asian countries like Thailand, Malaysia, Indonesia and India. In your opinion,
what forces are driving Japanese investments in these regions?
14.3 Transfer Pricing – Payments to and from Foreign Affiliates

MNCs in order to minimise their global tax liability, can have suitable transfer pricing strategies.
Transfer price is an accounting value assigned to a good or service transferred from one affiliate
to another. With higher transfer price, the larger will be the gross profit of the transferring
division relative to the receiving division. Consequently, it is beneficial to follow a high mark-
up policy on transferred goods and services from the parent to a foreign affiliate when the
income tax rate in the host country is greater than the tax rate in the parent company because of
lower taxable income in the high-tax cost country. On the other hand, when the parent company
has a higher tax rate, a low mark up policy will enable higher taxable income in the host country
and corresponding higher dividend remittance, which again will bear the high tax rate. However,
if foreign source retained earnings were needed for re-investment in the host country, a low
mark-up policy would result in tax savings (assuming that undistributed profits are not subject
to high tax in the host country).

Government authorities are quite aware of transfer pricing schemes used by MNCs to reduce
their worldwide tax liability and most countries have regulations, controlling transfer prices.
These regulations state that the transfer price must reflect an arm’s-length price i.e., a price, the
selling affiliate would charge to an unrelated customer for similar goods or services. However,
an arm’s-length price is difficult to establish and evaluate, thus, there exists opportunity for
some argument by an MNC to use transfer pricing strategies to reduce its worldwide tax liability.

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