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Chapter 25

Chapter 25. Taxation of International Transactions. The Big Picture (slide 1 of 3). VoiceCo, a domestic corporation, designs, manufactures, and sells specialty microphones for use in theaters. All of its activities take place in Florida

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Chapter 25

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  1. Chapter 25 Taxation of International Transactions

  2. The Big Picture (slide 1 of 3) VoiceCo, a domestic corporation, designs, manufactures, and sells specialty microphones for use in theaters. All of its activities take place in Florida But, it ships products to customers all over the United States. When it receives some inquiries about its products from foreign customers, VoiceCo decides to test the foreign market and places ads in foreign trade journals. Soon it is taking orders from foreign customers.

  3. The Big Picture (slide 2 of 3) VoiceCo is concerned about its potential foreign income tax exposure. Although it has no assets or employees in the foreign jurisdictions, it now is involved in international commerce and has many questions. Is VoiceCo subject to income taxes in foreign countries? Must it pay U.S. income taxes on the profits from its foreign sales? What if VoiceCo pays taxes to other countries? Does it receive any benefit from these payments on its U.S. tax return?

  4. The Big Picture (slide 3 of 3) Suppose that VoiceCo establishes a manufacturing plant in Ireland. VoiceCo incorporates the Irish operation as VoiceCo-Ireland, a foreign corporation. Ireland imposes only a 12.5% tax on VoiceCo-Ireland’s profits. So long as VoiceCo-Ireland does not distribute profits to VoiceCo, will the profits escape U.S. taxation? What are the consequences to VoiceCo of being the owner of a so-called controlled foreign corporation? Does it have any reporting requirements with the IRS? Read the chapter and formulate your response.

  5. Overview of International Taxation (slide 1 of 2) The U.S. taxes U.S. taxpayers on “worldwide” income The U.S. allows a Foreign Tax Credit to be claimed against the U.S. tax to reduce double-taxation (U.S. and foreign) of the same income

  6. Overview of International Taxation (slide 2 of 2) • For foreign taxpayers, the U.S. generally taxes only income earned within its borders • The U.S. taxation of cross-border transactions can be organized in terms of: • Outbound taxation • Refers to the U.S. taxation of foreign-source income earned by U.S. taxpayers • Inbound taxation • Refers to the U.S. taxation of U.S.-source income earned by foreign taxpayers

  7. U.S. Taxation of Cross-Border Transactions

  8. The Big Picture – Example 2Double Taxation Return to the facts of The Big Picture on p. 25-2. Assume that VoiceCo operates an unincorporated manufacturing branch in Singapore. This branch income is taxed in the U.S. as part of Voice-Co’s worldwide income and also in Singapore. Without the foreign tax credit to mitigate this double taxation, VoiceCo would suffer an excessive tax burden and could not compete in a global environment.

  9. The Big Picture – Example 3Inbound Taxation Return to the facts of The Big Picture on p. 25-2. VoiceCo’s major competitor is a Swiss-based foreign corporation with operations in the United States. Although not a U.S. person, the Swiss competitor is taxed in the United States on its U.S.-source business income. If the Swiss competitor could operate free of U.S. tax, VoiceCo would face a serious competitive disadvantage.

  10. International Tax Treaties(slide 1 of 3) • Tax treaties exist between the U.S. and many other countries • Provisions generally override the treatment called for under the Internal Revenue Code or foreign tax statutes • Generally provide taxing rights for the taxable income of residents of one treaty country who have income sourced in the other treaty country

  11. International Tax Treaties (slide 2 of 3) • Tax treaties generally: • Give one country primary taxing rights, and • Require the other country to allow a credit for the taxes paid on the twice-taxed income • Which country receives primary taxing rights usually depends on • The residence of the taxpayer, or • The presence of a permanent establishment • Generally, a permanent establishment is a branch, office, factory, workshop, warehouse, or other fixed place of business

  12. International Tax Treaties (slide 3 of 3) • Most U.S. income tax treaties reduce withholding on certain items of investment income • e.g., Treaties with France and Sweden reduce withholding on dividends to 15% and on certain interest to zero • Many new treaties (e.g., with the United Kingdom and Australia) provide for no withholding on dividend payments to parent corporations • The U.S. has developed a Model Income Tax Convention as the starting point for negotiating income tax treaties with other countries

  13. Sourcing of Income (slide 1 of 9) • Interest income • Interest income from the U.S. government, the District of Columbia, from U.S. corp. and from noncorporate U.S. residents is treated as U.S. source income • Exceptions • Certain interest received from a U.S. corp. that earned ≥ 80% of its active business income from foreign sources over the prior 3 year period is treated as foreign-source income • Interest received on amounts deposited with a foreign branch of a U.S. corp. is treated as foreign-source income if the branch is engaged in the commercial banking business

  14. Sourcing of Income (slide 2 of 9) • Dividend income • Dividends received from domestic corps. are sourced inside the U.S. • Generally, dividends paid by a foreign corp. are foreign-source income • Exception - If ≥ 25% of foreign corp.’s income is effectively connected with a U.S. trade or business for the 3 tax years immediately preceding dividend payment, that percentage of the dividend is treated as U.S.-source income

  15. Sourcing of Income (slide 3 of 9) • Personal services income • Sourced where the services are performed • A limited commercial traveler exception applies to non-resident aliens in the U.S. 90 days or less during the tax year • If U.S. compensation does not exceed $3,000 and the services are performed for a non-U.S. enterprise not engaged in a U.S. trade or business, the income is not U.S. source

  16. Sourcing of Income (slide 4 of 9) • Rents and Royalties • Income received for tangible property (rents) is sourced in country in which rental property is located • Income received for intangible property (royalties) is sourced where property producing the income is used

  17. Sourcing of Income (slide 5 of 9) • Sale or exchange of property • Generally, the location of real property determines the source of any income derived from the property • Income from sale of personal property depends on several factors, including: • Whether the property was produced by the seller • The type of property sold (e.g., inventory or a capital asset) • The residence of the seller

  18. Sourcing of Income (slide 6 of 9) • Sale or exchange of property (cont’d) • Generally, income, gain, or profit from the sale of personal property is sourced according to the residence of the seller • Income from the sale of purchased inventory is sourced based on where the sale takes place

  19. Sourcing of Income (slide 7 of 9) • Sale or exchange of property (cont’d) • When the seller has produced the inventory property • Income must be apportioned between the country of production and the country of sale • 50/50 allocation is used unless taxpayer elects to use the independent factory price or the books and records method

  20. Sourcing of Income (slide 8 of 9) • Sale or exchange of property (cont’d) • Income from the sale of personal property other than inventory is sourced at the residence of the seller unless: • Gain on the sale of depreciable personal property • Sourced according to prior depreciation deductions • Any excess gain is sourced the same as the sale of inventory • Gain on the sale of intangibles • Sourced according to prior amortization • Contingent payments are sourced as royalty income

  21. Sourcing of Income (slide 9 of 9) • Sale or exchange of property (cont’d) • Gain attributable to an office or fixed place of business maintained outside the U.S. by a U.S. resident is foreign-source income • Income or gain attributable to an office or fixed place of business maintained in the U.S. by a nonresident is U.S.-source income • Special rules apply to transportation and communication income

  22. Allocation and Apportionment of Deductions (slide 1 of 4) • Deductions and losses must be allocated and apportioned between U.S.- and foreign-source income • Deductions directly related to an activity or property are allocated to classes of income • Then, deductions are apportioned between statutory and residual groupings • A deduction not definitely related to any class of gross income is ratably allocated to all classes of gross income • Then apportioned between U.S.- and foreign-source income

  23. Allocation and Apportionment of Deductions (slide 2 of 4) • Interest expense • Allocated and apportioned to all activities and property regardless of the specific purpose for incurring the debt • Allocation and apportionment is based on either FMV or tax book value of assets • Special rules apply in an affiliated group setting

  24. Allocation and Apportionment of Deductions (slide 3 of 4) • Special rules apply to: • Research and development expenditures • Certain stewardship expenses • Legal and accounting fees • Income taxes • Losses

  25. Allocation and Apportionment of Deductions (slide 4 of 4) • §482 gives the IRS the power to reallocate income, deductions, credits or allowances between or among related persons when • Necessary to prevent the evasion of taxes, or • To reflect income more clearly

  26. The Big Picture – Example 9Apportionment Of Interest Expense Return to the facts of The Big Picture on p. 25-2. Assume that VoiceCo generates U.S.- source and foreign-source gross income for the current year. VoiceCo’s assets (tax book value) are as follows. Assets generating U.S.-source income $18,000,000 Assets generating foreign-source income 5,000,000 $23,000,000 VoiceCo incurs interest expense of $800,000 for the current year. Using the tax book value method, interest expense is apportioned to foreign-source income as follows. $5,000,000 (foreign assets) $23,000,000 (total assets) X $800,000 = $173,913

  27. Transfer Pricing Example (slide 1 of 2)

  28. Transfer Pricing Example (slide 2 of 2)

  29. Foreign Currency Transactions(slide 1 of 4) • May be necessary to translate amounts denominated in foreign currency into U.S. dollars • Major tax issues related to foreign currency exchange include: • Character of gain/loss (capital or ordinary) • Date of recognition of gain/loss • Source of foreign currency gain/loss

  30. Foreign Currency Transactions(slide 2 of 4) • Important concepts related to tax treatment of foreign currency exchange transactions include: • Foreign currency is treated as property other than money • Gain/loss is considered separately from underlying transaction • No gain/loss is recognized until a transaction is closed

  31. Foreign Currency Transactions(slide 3 of 4) • Functional currency approach under SFAS 52 is used for tax purposes • All income tax determinations are made in taxpayer’s functional currency • Taxpayer’s default functional currency is the U.S. dollar

  32. Foreign Currency Transactions(slide 4 of 4) • A qualified business unit (QBU) operating in a foreign country uses that country’s currency as its functional currency • QBU is a separate and clearly identified unit of a taxpayer’s trade or business (e.g., a foreign branch) • An individual is not a QBU but a trade or business conducted by a taxpayer may be a QBU

  33. Foreign Branch Currency Exchange Treatment (slide 1 of 2) • When foreign branch operations use a foreign currency as functional currency • Compute profit/loss in foreign currency • Translate into U.S. dollar using average exchange rate for the year

  34. Foreign Branch Currency Exchange Treatment (slide 2 of 2) • Exchange gains/losses are recognized on remittances from the branch • Gain/loss is ordinary • Sourced according to income to which the remittance is attributable

  35. Distributions From Foreign Corporations • Included in income at exchange rate in effect on date of distribution • No exchange gain/loss is recognized • Deemed dividend distributions under Subpart F are translated at average exchange rate for tax year • Exchange gain/loss can arise when an actual distribution of this previously taxed income is made

  36. Foreign Taxes • For purposes of the foreign tax credit, taxes accrued are translated at the average exchange rate for the tax year • An exception to this rule requires translation at the rate taxes were actually paid • If paid within 2 years of accrual and differ from accrued amount due to exchange rate fluctuations, no redetermination is required • Otherwise, where taxes paid differ from amount accrued, a redetermination is required

  37. The Big Picture – Example 13Apportionment Of Interest Expense Return to the facts of The Big Picture on p. 25-2. Assume that VoiceCo operates a foreign branch. Foreign taxes attributable to branch income amount to 5,000K (a foreign currency). The taxes are paid within two years of being accrued. The average foreign exchange rate for the tax year to which the foreign taxes relate is .5K:$1. On the date the taxes are paid, the rate is .6K:$1. No redetermination is required, and VoiceCo reports foreign taxes of $10,000 for purposes of the foreign tax credit.

  38. Tax Incentives For Exports (slide 1 of 2) • Prior tax law contained a special tax incentive for U.S. taxpayers exporting goods • Allowed U.S. taxpayers to exclude extraterritorial income (ETI) from U.S. taxation • The American Jobs Creation Act of 2004 repealed the ETI exclusion

  39. Tax Incentives For Exports (slide 2 of 2) • The American Jobs Creation Act of 2004 created a new broad-based “domestic production activities deduction” • The domestic production activities deduction is equal to 9% of the taxpayer’s qualified production activities income subject to several limitations • Unlike the earlier ETI exclusion, the DPAD does not require exporting or any other activity outside the United States

  40. Cross-Border Asset Transfers • Tax consequences of transferring assets to a foreign corporation depend on • The nature of the exchange • The assets involved • Income potential of the property • Character of the property in the hands of the transferor or transferee

  41. Outbound Transfers(slide 1 of 3) • Similar to exchanges of assets for corporate stock of a domestic corporation, realized gain/loss may be deferred on certain outbound capital changes, moving corporate business outside the U.S. • Starting a new corp outside the U.S. • Liquidating a U.S. subsidiary into an existing non-U.S. subsidiary • Others

  42. Outbound Transfers(slide 2 of 3) • Transfer of trade or business property generally qualifies for deferral of gain or loss • Transfer of “tainted” assets triggers immediate recognition of gain but not loss • In addition, depreciation and other recapture potential must be recognized to the extent of gain realized

  43. Outbound Transfers (slide 3 of 3) • “Tainted” assets include: • Inventory • Installment obligations and unrealized accounts receivable • Foreign currency • Property leased by the transferor unless the transferee is the lessee

  44. Cross-border Mergers (slide 1 of 2) • The American Jobs Creation Act of 2004 created strict rules to deter owners from turning domestic entities into foreign entities • A domestic corp. or partnership continues to be treated as domestic if: • A foreign corp. acquires substantially all of its properties after March 4, 2003 • The former owners of the U.S. corp. (or partnership) hold ≥ 80% of foreign corp.’s stock after transaction • The foreign corp. does not have substantial business activities in its country of incorporation

  45. Cross-border Mergers(slide 2 of 2) • If former owners own at least 60% but less than 80% of new corp. • Foreign entity is treated as foreign • Corporate-level taxes imposed due to the transfer cannot be offset with NOLs, foreign tax credits, or certain other tax attributes • An excise tax is also imposed on the value of certain stock held by insiders during the 12-month period beginning 6 months before the date of inversion

  46. Inbound and Offshore Transfers • U.S. persons involved in an inbound or offshore transfer involving stock of a controlled foreign corporation (CFC) • Generally, recognize dividend income to the extent of their pro rata share of previously untaxed E & P of the foreign corporation, or • Enter into a gain recognition agreement with the IRS that may allow income to be deferred

  47. Controlled Foreign Corporations (slide 1 of 3) • Certain types of income generated by a controlled foreign corporation (CFC) are currently included in income by U.S. shareholders without regard to actual distributions including: • Pro rata share of Subpart F income • Increase in earnings that the CFC has invested in U.S. property

  48. Controlled Foreign Corporations (slide 2 of 3) • Subpart F Income includes the following • Insurance income (§ 953) • Foreign base company income (§ 954) • International boycott factor income (§ 999) • Illegal bribes • Income derived from a § 901(j) foreign country

  49. Controlled Foreign Corporations (slide 3 of 3) • To apply, foreign corp must have been a CFC for an uninterrupted period of 30 days or more during tax year • A CFC is any foreign corp in which > 50% of total voting power or value is owned by U.S. shareholders on any day of tax year • U.S. shareholder is a U.S. person who owns (directly or indirectly) 10% or more of voting stock of the foreign corp

  50. U.S. Shareholder’s Income from CFC

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