 Hello and welcome to this session. This is Professor Farhad and this session we would look at withholding taxes and thin capitalization as they relate to international accounting and international taxation. This topic is covered in a CPA and ACCA exam. As always, if you haven't connected with me on LinkedIn, please do so. YouTube is where you would need to subscribe. I have 1500 plus accounting, auditing, tax and finance lectures. Please like my lectures, share them, put them in the playlist. If you're watching my lectures, it means you're benefiting. Share them so other people might benefit as well. If you're looking for additional resources, more than the lectures, you can visit my website where I can download the PowerPoint slides, work multiple choice questions, quizzes, additional exercises about the lectures. I strongly encourage you to visit. Astudypal.co is an artificial intelligence driven study body that matches you with someone who's studying for the CPA or CFA. If you're looking for a study body, they're in 85 countries in 2800 cities. So let's talk about withholding taxes. What is tax withholding and how does it work? So let me give you an example on a personal level, this way you will understand. Let's assume you are a foreign citizen, not only foreign citizen, foreign citizen means you are not a resident of the US. This is what I mean by foreign citizen. And let's assume you invest in Apple computers and you happen to receive for a particular year $10,000 in dividend from Apple. They pay dividend and you receive it. Now the US government requires Apple to withhold 30% because the foreign citizen is not required to file a tax return. Now remember we're not talking about resident people in the US. Let's assume you are from France, living in France, but you invested in Apple. Now can you get this money back? For example, if you receive 10,000 minus 3,000, you'd receive 7,000. Well it all depends on the tax treaties or if you're going to get a tax credit in your country, but that's a different story. But the point is this is how tax withholding work. If Apple pays you and you are not a citizen of the US, they will withhold the taxes, 30% taxes. Now I happen to have my first job out of college. I work with a company, well now it's part of Bank of America, Merrill Lynch, and I used to work under what's called employee stock option plan where your company, if you work for example for Intel or PepsiCo, they will grant you options, stock options, and what you do is you will exercise those options, sell your options and get your money. If you were a foreign citizen and a lot of Intel executives, they were in Asia, East Asia, and what happened is if they did not have a particular form, in other words, I remember the form used to be called W, I believe W9. If they did not have a W9 form on hand, then we were required on behalf of the US government to withheld, I don't remember how much it was, was 25 or 30% unblocking over 20 years ago. So we are required to withheld a certain amount of taxes. Now if they filed the W9, it means the US they have, they know who filed and in case they get a credit in their own country. So it all depends if they filed the form then we will not withheld. So basically the form will tell the US government there's some sort of an agreement between the US and that country and that was the case. But just want to let you know that I saw this up front and personal. People were not happy when they did not have the W9 and they received 25% less than what they thought they would receive. Okay, anyhow. So withholding taxes applies the same to companies. So withholding taxes are also imposed on payment made to foreign parent companies or foreign affiliate companies. So if you are operating as a company and you want to make payment to your parent company and you are operating in a different country, you might be subject to withholding. And there are three types of three types of payment that are subject to withholding. If you pay dividend to the parent company, interest and royalties. Now withholding rate might vary across countries and in some countries varies by the type of the payment or the recipient. So there is no one set rate. For example in the US, the US withholding rate on payment is generally 30% on interest on bank deposit and on certain registered debt and instrument debt is 0%. But bank deposit, if you have a bank deposit in the US and you don't have the proper forms, they will they will withhold 30%. Again, the reason I say the proper forms because sometimes you don't have to withhold anything depending on the tax treaty between the US and where you are a citizen. But again, we'll talk about this later on. But the withholding means the money is taken up front. Okay, let's take a look at just for example the US, they withhold 30% on dividend, 30% on interest for the bank and 30% on royalties. The UK don't withhold anything on dividend. France don't withhold anything on interest payment. Germany nothing on interest payment. Notice Hong Kong, no dividend, no interest payment. I remember Hong Kong as a tax haven country. So just kind of gives gives you an idea. Again, Singapore 0, again Singapore again in your textbook but they may not be tax havens. Switzerland same thing, zero on interest, zero on royalties but they would help 35% on dividend just to give you an idea. Now, since we have those different withholding rates on different type of payment, now this gives the company, the multinational the option to finance themselves in a way to minimize their taxes or increase their cash flow. So the differences in those withholding rates on different type of payment provide an opportunity to reduce taxes by altering the method of financing a company. So when you finance a company, you finance through debt and through equity remember, hopefully you remember this, assets equal to liabilities plus equity. So you finance yourself as important. For example, let's assume a Chinese company planning to establish a facility in France, they would prefer that future cash payment received from the French subsidiaries to be a form of interest. Why? Because the French don't withhold any money on interest. Now, if the subsidiary pays the parent Chinese company in dividend, then the French government will withhold 30%. So the objective here by the Chinese company is to finance as much as possible with loan rather than equity. Why? Because when the subsidiary pays interest on that loan, when they send that money to China in form of interest payment, then they don't have to withhold 30%. For example, rather than the Chinese parent investing 10 million euros in equity to establish the French operation, what they can do, they can invest 5 million and 5 million rather than the whole thing 10 million in equity. Why? Because the debt, it's going to be, you're not going to, when they send the interest payment, they will not withhold any money. They will not withhold any money. Okay? Interest on the loan which is cash payment to the Chinese parent company would be exempt from the French withholding tax whereas any dividend paid to foreign to on the capital contribution would be taxed at 30%. So that's why they will finance it. Now, you might be saying, well, that's easy. Let's just use that. Well, that's not the case because if the company had what's called thin capitalization, thin capitalization means they have mostly in debt, mostly the company is established by providing debt rather than equity. This is called thin capitalization. When there's a thin capitalization, how do you determine it's this thin capitalization? We're going to find out what each country required but the point is thin capitalization means there's little equity in a lot of that. So when you finance the company, if we go back to this example, if we say, okay, we're going to invest 1 million and 9 million, well, definitely this is for every 1 million dollar invested or 1 million euros you're investing 9, that's thin capitalization. The equity holders are not much. So several countries have a lower rate of withholding on interest than dividend. In addition, the good thing about interest, interest is it has its disadvantage. We were talking about the advantages here. Interest payment are generally tax deductible whereas dividend are not. So financing yourself with debt has a tax advantage because one thing, the withholding tax rate is lower in certain countries and you can deduct the interest on your taxes. There's often incentive for companies to finance their operation with as much debt as possible and with little equity as possible again because you have double incentive. Now that has its also that has its disadvantage because you have to come up with the payment and now that, you know, fixed payment every month or fixed payment every quarter and companies may not have the cash flow to meet those payments. But when that's the case, when you have a lot of debt and a little bit of equity, this is known as thin capitalization. In several countries had set limits on how thinly your company can be capitalized. So if you go, you know, too crazy, then they're going to say, hold on a second, if you want to, you're not going to get the benefit of it. Just to give you an idea in France, interest paid to foreign parent will not be tax deductible for the amount of the loan that exceed 150 percent of equity capital. Simply put, the ratio of debt to equity simply put debt to equity cannot exceed 150 percent. Simply put, if you have $150 in debt, you must have 150 in equity. Now, if what happened if you have less than 150, which is this is equal to 150 percent, and under those circumstances, you can deduct all the interest on the debt. But let's assume you have $180 in debt and 100 in equity. Now that additional $30, you cannot deduct the interest on them. You cannot deduct the interest. You can only deduct the interest up to 150 percent as of debt to equity. So simply put, if the equity capital is a million, you could have loans financing the company up to $1.5 million that you can deduct. Now you could have more than $1.5 million in loans to finance the company, but anything in addition to $1.5 million, the interest paid on that addition is not tax deductible. That's what we're saying. Now, for example, in Mexico, they're a little bit more liberal. In Mexico, you could go up to $3.1 before they start to take that deduction out. So in Mexico, if you have $100 million in equity, you can provide $300 million in debt, because that's $300 million divided by $100 million is three. So you're in good shape. So notice in Mexico, they're a little bit more liberal. They allow you to be more thinly capitalized than the French company. In some countries, again, why? Because companies are aware of this. They're aware that that multinational may go through this process. Now, if you have any questions or if you want additional lectures, please visit my website, farhatlectures.com, and on the website, you could have additional resources such as the PowerPoint slides, additional exercises. In the next session, I will cover the value added taxes. Please subscribe, like the videos, share them, stay motivated, and good luck.