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International Tax Jurisdiction—Basic Concepts

International Tax Jurisdiction—Basic Concepts. Key issues governments must resolve when taxing cross-border trade -- What persons to tax? -- What income to tax? Factors that trigger taxation. Personal relationship  Country of incorporation or residence.

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International Tax Jurisdiction—Basic Concepts

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  1. International Tax Jurisdiction—Basic Concepts • Key issues governments must resolve when taxing cross-border trade -- What persons to tax? -- What income to tax? • Factors that trigger taxation

  2. Personal relationship  Country of incorporation or residence • Economic relationship  Country in which a business has income producing assets or activities

  3. Outbound Transactions Foreign Source Income Domestic Foreign Corporation Operations Foreign Investment • “U.S. persons” (§7701) * Foreign Source Income • U.S. citizens • Resident aliens • Domestic corporations • Domestic Partnerships

  4. Inbound Transactions U.S. Source Income ForeignU.S. CorporationOperations U.S. Investment • Foreign Persons (§7701) * US Source Income • Non resident aliens • Foreign corporations • Foreign partnerships

  5. U.S. Taxation of Outbound Transactions Foreign Source Income Domestic Foreign Corporation Operations Foreign Investment • Credit System • Low-tax foreign countries U.S. collects “residual” U.S. tax • High-tax foreign countries U.S. collects no tax and credit is limited to US tax on foreign income • Major Exceptions • Deferral privilege (subject to Subpart F, PFIC and FPHC regimes) • Foreign earned income exclusion (§ 911)

  6. U.S. Taxation of Inbound Transactions U.S. Source Income ForeignU.S. CorporationOperations U.S. Investment • Two-pronged territorial system • U.S. branch operations Net basis tax on “effectively connected” income • Passive foreign investors Gross basis withholding on U.S. source non business income • Major exceptions • Capital gains and portfolio interest exemptions • U.S. real property interests (FIRPTA) • Treaty reductions

  7. Computing the Foreign Tax Credit • Procedure • Compute creditable taxes (“All or Nothing”) • Compute foreign tax credit limitation • Credit = Lesser of creditable taxes or FTCL • Excess credits: Back 2 years, forward 5 years • Computing creditable taxes (Step 1 above) • Qualifying (by treaty) foreign levies (§§ 901,903) • Taxpayers entitled to claim a credit (§ 901) • Currency translation (average exchange rate for year) (§ 986) • Cash v. accrual basis accounting (§905) [Accrual method election available]

  8. Foreign Tax Credit Limitation (§904) • Purpose • Limit credit to U.S. tax on foreign income • Credit cannot exceed U.S. tax on U.S. source income • Formula Pre-credit = Foreign source taxable income U.S. tax Total taxable income

  9. Excess Credit vs. Excess Limitation—Impact of Foreign Tax Rate Facts: • Domestic corporation has a foreign branch. (Note: Branches include legal entities that are “disregarded” under the check-the-box regulations) • Total income of $ 100 is attributable entirely to foreign branch. • U.S. tax rate = 35% Case 1: 20% foreign tax rate  “Excess Limitation” U.S. tax return Taxable Income $ 100 Tax rate 35% Pre-credit tax $ 35 Credit (limit) 20 U.S. tax $ 15 Foreign tax return Taxable income $ 100 Tax rate 20% Foreign tax $ 20*

  10. Excess Credit vs. Excess Limitation—Impact of Foreign Tax Rate (continued) Case 2: 50% foreign tax rate • “Excess credits” $ 50 Foreign tax (b) - $ 35 U.S. credit limit (a) = $ 15 excess credit U.S. tax return Taxable Income $ 100 Tax rate 35% Pre-credit tax $ 35 Credit (foreign tax) (a) (35) U.S. tax $ 0 Foreign tax return Taxable income $ 100 Tax rate 50% Foreign tax (b) $ 50

  11. Excess Credit vs. Excess Limitation—Planning Issues • Excess limitation position (Subpart F issues) • Tax on foreign income equals foreign tax + residual US tax • Planning: Defer residual US tax • Excess credit position (§ 861 planning) • Tax on foreign income equals higher foreign tax • Planning • Reduce foreign taxes • Increase allowable credit

  12. Strategies for Eliminating Excess Credits • Foreign tax reduction planning (discussed later in the course) • Foreign tax credit limitation planning (§ 861) • Increase foreign source portion of total taxable income • Transfer title overseas on export sales • Reduce expenses apportioned to foreign source income • Cross-crediting • Blend low and high tax foreign source income within the same Foreign tax credit limitation basket.

  13. Cross Crediting—An Example Case 1: • Domestic corporation has a branch in country X • Total income of $ 100 is attributable entirely to branch in X • Tax rates: U.S. = 35% and X = 50% Question: What is the amount of the excess credits? Foreign income taxes (50% of $ 100) $ 50 Average foreign tax rate 50% Limitation: (a) Total taxable income $ 100 (b) Pre-credit U.S. tax ($100 x 35%) 35 (c) Foreign source taxable income 100 Limitation [b x (c ÷a)]35 Excess credits $ 15

  14. Cross Crediting—Example (Continued) Case 2: • Domestic corporation also has branch in country Y • Branch generates $ 100 profit • Country Y tax rate is 25% Question: What is the amount of the excess credits? Foreign income taxes (50% x $ 100) + (25% x $ 100) $ 75 Average foreign tax rate ( $ 75 ÷ $ 200) 37.5% Limitation: (a) Total taxable income ( $ 100 + $ 100) $ 200 (b) Pre-credit U.S. tax ($ 200 x 35%) 70 (c) Foreign source taxable income 200 Limitation [b x (c ÷ a)] ` 70 Excess credits $ 5

  15. §904(d) Separate Income Limitations or “Baskets”—Principal Features • Passive income (usually low tax income) • “mini-baskets” • High withholding tax interest • Dividends from >10%/<50% companies • Financial services income (banks) • Shipping income (low tax jurisdictions) • General limitation income, which includes most active business profits (e.g. e-commerce) These are usually high income tax jurisdictions

  16. Separate Income Limitations (or Baskets) • Formula • Pre-credit U.S. tax X Separate basket foreign tax inc. Total taxable income • Computation • Items of foreign source income and deduction must be allocated among the baskets • Foreign income taxes must be allocated among the baskets

  17. Form 1118 Foreign Tax Credit • Who must file • Corporations claiming FTC • File separate 1118 for each basket • Contents • Sch A--Separate basket taxable income • Sch B--Foreign tax summary and credit computation • Schs C, D, and E--Deemed paid credit • Schs F, G, and H--Supporting computations

  18. Dividend Repatriations from a Foreign Corporation to a U.S. Parent—Tax Consequences • Foreign withholding taxes • Pre-credit U.S. tax on dividend income • Foreign tax credits • §901 direct credit for withholding tax borne by U.S. parent (branch arrangements, not a corporation) • §902 deemed paid credit for taxes paid by a foreign subsidiary (the dividend from the subsidiary is net of the withholding tax)

  19. The Deemed Paid Credit—An addition to the actual withholding tax paid • Rationale: Tax parity between branches and subsidiaries (for branches all income is combined in gross income; for foreign subsidiaries the income is not combined) • Qualification requirements (§902) • Shareholder must be a domestic corporation (does not include S corporations) • Shareholder must own 10% or more of voting stock • Shareholder must receive dividend distribution • §78 Gross-up income • Equals amount of deemed paid credit • Tracing foreign taxes to dividends (see next slide)

  20. Pooling Approach of §902(a) Foreign Dividend received Deemed = corporation’s X by shareholder Paid Creditpost-1986 Foreign corporation’s foreign income 1986 undistributed taxes E & P (excluding the current dividend)

  21. FTCL basketing rules of §904(d) • Dividends received from a “CFC” • Controlled Foreign Corporation: More than 50% ownership requirement—follows §902 (a) pooling approach • Dividends received from a 10/50 corporation • Look-through rule applies; Dividends from E & P accumulated before 2003 are assigned to a single company basket that applies to all 10/50 companies. Dividends from each 10/50 corporation from E & P accumulated after 2002 is assigned based on separate baskets. • Definition of 10/50: The domestic corporation owns between 10% and 50% of the foreign corporation

  22. Mechanics of CFC Look-through Rule • Step 1 Post-1986 undistributed • Portion of dividend = E & P attributable to basket attributable to basket Total post –1986 undistributed E & P • Step 2 • Deemed paid Portion of dividend taxes associated = attributable to basket with basket Total post –1986 undistributed E & P attributable to basket

  23. Deemed Paid Credit – Lower Tier Corporations

  24. Deemed Paid Credit – Lower Tier Corporations (Continued) • Qualification requirements • Minimum 10% direct ownership at each level • Minimum 5% indirect ownership through chain • Dividend Distributions up to U.S. parent • Number of qualifying tiers • Historically limited to 1st, 2nd, & 3rd tiers • TRA 1997. Extended to 4th, 5th , & 6th tiers

  25. Dividend Repatriations -- Planning • Tax consequences • Low tax countries: Residual U.S. tax • High tax countries: Excess credits • Annual repatriation program • Coordinate dividends to exploit cross-crediting • Structure investments to minimize 10/50 company baskets • Use tax treaties to minimize withholding taxes

  26. Repatriating Profits – Dividends vs. Interest

  27. Earnings Stripping – An Example P’s U.S. tax return Dividend $ 50 Gross-up 50 Taxable income $100 Tax rate . 35 Pre-credit tax $ 35 Credit (limitation) (35) U.S. tax $ 0 S’s foreign tax return Profit pre-interest $ 100 Interest expense 0 Taxable income $ 100 Tax rate .50 Foreign tax $ 50 Facts: • P, a domestic corporation, owns 100% of S, a foreign corporation • S Profit before interest and taxes = $ 100 • Tax rates: U.S. = 35%, Foreign = 50% • Assume no foreign withholding tax on interest or dividends Conclusion: Total tax = $ 50 (earnings taxed once at the higher foreign rate)

  28. Earnings Stripping—Example (Continued) P’s U.S. tax return Interest Income $ 100 Gross-up 0 Taxable income $ 100 Tax rate .35 Pre-credit tax $ 35 Credit (0) U.S. tax $ 35 S’s foreign tax return Profit pre-interest $ 100 Interest expense 100 Taxable income $ 0 Tax rate .50 Foreign tax $ 0 Facts: • Earnings repatriated via interest payments • Total tax = $ 35 (Earnings taxed once at the U.S. rate)

  29. Importance of Sourcing Rules • U.S. persons • Taxed on worldwide income • Foreign source income impacts foreign tax credit limitation • Foreign persons • Taxed only on U.S. source income

  30. Maximizing the Foreign Tax Credit Limitation (§904) • Foreign tax Foreign source credit = Pre-credit X taxable income limitation U.S. tax Total taxable income • How to increase the limitation? • Gross Income  Recharacterize as foreign source income for U.S. tax purposes • Deductions  Recharacterize as U.S. source for U.S. tax purposes

  31. Overview of the Sourcing Process • Goal: Determine geographic origin of income • Two step process similar to allocation and apportionment of state income taxes • Gross Income (§ 863 to § 865) • Step 1: Determine statutory category • Step 2: Apply specific category rule • Deductions (Reg. 1.861-8) • Step 1: Allocate to a related class of gross income • Step 2: Apportion based on factual relation of deductions to gross income.

  32. Sourcing Rules—The General Rules (§§861, 862) Income Sourced in the United States (§861) • Interest—Interest received from the U.S. government, District of Columbia and from non-corporate U.S. residents or domestic corporations • Dividends—Dividends received from domestic corporations (other than certain possessions corporations) • Personal Services— Source is determined by the location in which the services are performed (inside or outside the United States) • Rents and Royalties—For tangible property, the country where the property is located, for intangible property, the country where the property is used. • Sale or Exchange of Real Property—Source is determined by the location of the property

  33. Sourcing Rules—The General Rules (Continued) Sale of Personal Property—Factors for Consideration • Whether the property was produced by the seller. • The type of property sold (e.g. inventory of capital asset) • The residence of the seller §865—Sale of Personal Property Other Than Inventory • Sourced at the Residence of the Seller • Gain on sale of depreciable personal property is sourced according to the prior depreciation deductions to the extent of the deductions. An excess is sourced the same as the sale of inventory. • Gain on sale of intangibles is sourced according to prior amortization deductions to the extent of the deductions. Contingent payments are sourced as royalty income. • Gain attributable to an office or fixed place of business maintained outside the U.S. by a U.S. resident is foreign-source income • Sourcing of losses depends on the nature of the property (Reg. 1.861-8(e)(7))

  34. Sourcing Rules for Inventory • §§ 861(a)(6) & 865 Sale of purchased inventory is sourced in the country where the sale takes place. The sale is deemed to take place when title passes (Reg. 1.861-7(c)) • When the seller produces the property the income must be apportioned between the country of production and the country of sale. • Referred to as “§863 (b)” income” • Seller must source the gross income under a 50/50 allocation method (see next slide) unless another method is elected. • Other methods are independent factory price and separate books and records.

  35. 50-50 Method for Sourcing Sales • Apply to Gross Profit, 50% to Sales and 50% to Property • The sales factor: • Export sales where title passes abroad Total export sales • Definition of “export sales” –Goods produced in the U.S. and sold for use, consumption or disposition abroad

  36. 50-50 Method: The Property Factor Average adjusted basis of foreign production assets Average adjusted basis of all production assets • Denominator • Includes assets used to produce inventory in the U.S. for sale abroad • Prorate assets used to produce inventory sold domestically and abroad • Excludes cash, receivables, inventory distribution and marketing assets • Average basis = (Beginning of year + end of year) ÷ 2 • Numerator • Assets in dominator that are physically located abroad • Numerator equals $0 if taxpayer has no foreign manufacturing facilities or owns foreign facilities through foreign subsidiaries.

  37. Sourcing Gross Income under §861—Some Important Exceptions • Interest Income • Certain interest received from a U.S. corporation that earned 80 percent or more of its active business income from foreign sources over the prior three period is treated as foreign source income. [80/20 corporations] • Income received on amounts deposited with a foreign branch of a U.S. corporation is also treated as foreign source income • High withholding tax interest is treated as a separate basket for FTCL purposes • Dividends • If 25% or more of a foreign corporation’s gross income for the three tax years immediately preceding the current tax year was effectively connected with the conduct of a U.S. trade or business, a special rule applies. The U.S. portion of gross income is equal to the proportion of gross income effectively connected with the conduct of a U.S. trade or business for the immediately preceding three-year period. • There is a withholding exemption for 80/20 corporations described above • Normally passive income for FTCL purposes, but special treatment for CFC’s, 10/50 corporations, DISC’s and FSC’s..

  38. §862 Income Sourced Outside the United States • Not as detailed or Specific as §861 • If income is not U.S. source income, then it is foreign source income. §862 applies to the following: • Interest • Dividends • Compensation for personal services • Income from the use or sale of property • Other income

  39. Source Rules for Deductions (Treasury Reg. 1.861-8)Step 1 Step 1: Allocation  Potential Classes of Gross Income • Compensation for services • Gross income from business • Royalties • Gains on dealings in property • Interest • Rents • Dividends

  40. Source Rules for Deductions (Treasury Reg. 1.861-8)Step 2 Step 2: Apportionment between U.S. and foreign source gross income  Potential Apportionment Bases • Gross income • Gross sales • Unit sales • Cost of goods sold • Profit contributions • Expenses incurred • Assets used • Salaries paid • Space used • Time spent

  41. Special Apportionment Rules • Interest expense—see next slide • Research and experimentation expenditures ordinarily are considered to be definitely related to all income reasonably connected with the relevant broad product category and are allocable to all items of gross income as a class [i.e., sales, royalty, and dividend income] related to that product category. After allocation of the research expenses, the expense is apportioned between the statutory and residual groupings of income, using either the sales (50/50) method or the optional gross income method. (Reg. 1.861-17) • State income taxes are considered definitely related and allocable to the class to which the asset would normally generate gross income. (Reg. 1.861-8(e)(65)(i) • Net operating losses are allocated and apportioned in the same manner as the deductions giving rise to the NOL deduction. Reg. 1. 861-8(e)(8)

  42. Special Apportionment Rules--Continued • Stewardship expenses—If services are provided for the benefit of the corporation as an investor , the services may be of a stewardship or overseeing character for which no charge is made. Deductions resulting from stewardship or overseeing functions are considered definitely related and allocable to dividends received or to be received from the related corporation. Reg. 1.861-8(e)(4) • Losses on sales of property—The deduction allowed for loss recognized on the sale of a capital asset or § 1231 asset is considered definitely related and allocable to the class to which the asset would normally generate gross income. Reg. 1.861-8(e)(7) and § 865 (j) • Legal and accounting fees are normally definitely related and allocable to the class of gross income for which the services are related. Reg. 1.861-8(e)(5)

  43. Source Rules for Interest Expense • Fungibility principle • Allocate interest to all gross income even if borrowing relates to specific asset • Apportionment base • Two methods available—fair market value or tax book value §864 (e)(2) • Affiliated groups • Treated as a single corporation for purposes of apportioning interest expense

  44. Worldwide Effective Tax Rate—Why It is Important • Impact reported earnings • Impacts cash flow • Impacts evaluation of tax director

  45. Examples of Impact of Foreign Operations on Effective Tax Rates • Caterpillar U.S. statutory rate 35.0% FSC benefit (3.2%) Other ` (1.2%) ` Effective tax rate 30.6% • Exxon/Mobil U.S. statutory rate 35.0% Operations in high tax countries 15.5% Other (6.2%) Effective tax rate 44.3% • Pfizer U.S. statutory rate 35.0% Operations in low tax countries (5.5%) Operations in Puerto Rico (2.2%) Other (2.5%) Effective tax rate 24.8%

  46. Planning for Foreign Operations by a U.S. Domestic Corporation • Goal: To minimize worldwide effective tax rate on foreign source income • U.S. tax on foreign income • Deferral • Foreign sales corporations and extraterritorial income exclusion • Foreign taxes • Reducing foreign taxes • Maximizing allowable U.S. credit

  47. Taking Advantage of Deferral—An Example

  48. Taking Advantage of Deferral--Continued • Deferral = 25% residual U.S. tax • Financial reporting: Can treat as permanent difference that increases current earnings (APB 23) • Other examples of low tax countries: Singapore and Hong Kong • Restrictions on deferral • Arm’s length transfer price • Subpart F • §367 outbound toll charge

  49. Operating in High Tax Foreign Countries – Example

  50. Operating in High Foreign Tax Countries--Continued • Problem: Excess foreign tax credits • Other examples of high tax countries: Canada and Germany • Planning: • Increase allowable credits • Reduce foreign taxes

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