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Prepared by the Staff of the Joint Committee on Taxation 2011

International Tax Overview: Comparison of Worldwide and Territorial Systems. Prepared by the Staff of the Joint Committee on Taxation 2011. Agenda. Agenda. International tax principles Alternative international tax systems Worldwide Territorial U.S. “ hybrid ” system

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Prepared by the Staff of the Joint Committee on Taxation 2011

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  1. International Tax Overview: Comparison of Worldwide and Territorial Systems Prepared by the Staff of the Joint Committee on Taxation2011

  2. Agenda Agenda • International tax principles • Alternative international tax systems • Worldwide • Territorial • U.S. “hybrid” system • Features of both worldwide & territorial systems • Benefits of deferral • Operation of the foreign tax credit • Administering the system • Transfer pricing • Income shifting • Expense allocation

  3. International Tax Principles International Tax Policies • International tax rules allocate rights to tax cross-border income • Cross-border income: income derived within one country by a resident of another country • A sovereign nation’s right to tax income derives from: • The residence of the income earner, or • The source of the income

  4. International Tax Systems: Alternatives Spectrum of Tax Systems • Worldwide: A country taxes residents on all income, regardless of source • Territorial: A country taxes only income derived within its borders, regardless of the residence of the earner • Generally, no country employs a pure worldwide or a pure territorial system

  5. If U.S. Had Pure Worldwide Tax System Worldwide Tax System • Tax all income, active and passive, U.S.-source and foreign-source, of U.S. firms, their subsidiaries and branches • Relieve double taxation through foreign tax credit • Tax neutrality for U.S. firms between operating in the U.S. and operating abroad

  6. If U.S. Had Pure Territorial Tax System Territorial Tax System • Tax U.S.-source income of U.S. and foreign firms • Exempt all foreign-source income earned through a foreign branch or foreign subsidiary • Tax neutrality between U.S. firms and foreign firms operating abroad

  7. U.S. “Hybrid” System US “Hybrid” System • Worldwide features • All income, domestic and foreign, of U.S. firms and branches is subject to U.S. tax, with a foreign tax credit provided • Territorial features • Active foreign income of foreign subsidiaries is generally not subject to U.S. tax on a current basis • U.S. tax is deferred until income is distributed to U.S. parent as a dividend

  8. Benefit of Deferral: Tax Rate Example Example with Deferral U.S. Corporation has $1,000 to invest in the U.S. or abroad. The annual return on the U.S. and foreign investment is 10% for five years. Foreign investment with deferral* Income Year 1 $1,000 x 10% = $100 Year 2 $1,100 x 10% = $110 Year 3 $1,210 x 10% = $121 Year 4 $1,331 x 10% = $133 Year 5 $1,464 x 10% = $146 Total pre-tax earnings $610 U.S. tax at 35% on repatriation $214 After-tax earnings $396 Without deferral, to generate the same after-tax earnings, tax rate would have to be 31% IncomeTax Year 1 $1,000 x 10% = $100 x 31% = $31 Year 2 $1,069 x 10% = $107 x 31% = $33 Year 3 $1,143 x 10% = $114 x 31% = $35 Year 4 $1,221 x 10% = $122 x 31% = $38 Year 5 $1,306 x 10% = $131 x 31% = $41 Total pre-tax earnings $574 Total tax at 31% $178 After-tax earnings $396 *Assumes no foreign tax for purposes of simplicity. The example is not intended to imply that actual active foreign income would not be subject to some level of foreign corporate income tax.

  9. Benefit of Deferral: Return on Investment Example with Deferral U.S. Corporation has $1,000 to invest in the U.S. or abroad. Foreign investment with deferral* Annual return on investment of 10% Income Year 1 $1,000 x 10% = $100 Year 2 $1,100 x 10% = $110 Year 3 $1,210 x 10% = $121 Year 4 $1,331 x 10% = $133 Year 5 $1,464 x 10% = $146 Total pre-tax earnings $610 U.S. tax on repatriation $214 After-tax earnings $396 Annual return on investment must be 10.6% to return the same after-tax earnings without deferral IncomeTax Year 1 $1,000 x 10.6% = $106 x 35% = $37 Year 2 $1,069 x 10.6% = $113 x 35% = $40 Year 3 $1,143 x 10.6% = $121 x 35% = $42 Year 4 $1,221 x 10.6% = $130 x 35% = $45 Year 5 $1,305 x 10.6% = $138 x 35% = $49 Total pre-tax earnings at 10.6% $608 Total U.S. tax $213 After-tax earnings $395 *Assumes no foreign tax for purposes of simplicity. The example is not intended to imply that actual active foreign income would not be subject to some level of foreign corporate income tax.

  10. Foreign Tax Credit Relief of Double Taxation • Worldwide: foreign tax credit for foreign taxes paid on foreign earnings • Territorial: exemption of foreign earnings from tax base

  11. Foreign Tax Credit Foreign Tax Credit • Purpose: to prevent double taxation of foreign earnings • Available for income and withholding taxes paid to a foreign country • Subject to limitation (Appendix B)

  12. Foreign Tax Credit Example Double Tax Relief: Low Tax Example U.S. Corp $3,000 U.S.-source income Dividend of $800 Controlled Foreign Corporation $1,000 foreign-source income 20% tax rate

  13. Low Tax Example: Foreign Tax Credit With Foreign Tax Credit

  14. Low Tax Example: Dividend Exemption With Foreign Tax Credit

  15. FTC Limitation Example Double Tax Relief: High Tax Example U.S. Corp $3,000 U.S.-source income Dividend of $500 Controlled Foreign Corporation $1,000 foreign-source income 50% tax rate

  16. High Tax Example: Foreign Tax Credit With FTC Limitation

  17. High Tax Example: Dividend Exemption With FTC Limitation

  18. Bringing Foreign Earnings Back to the U.S. • Dividends from active foreign operations • Worldwide system: • Dividend is included in domestic taxable income • Foreign tax credit may be available • Residual tax may be due • Exemption system: • Dividend is excluded from domestic taxable income • No residual tax due

  19. Bringing Foreign Earnings Back to the U.S. • Royalties and interest differ from dividends: • Royalties and interest are generally deductible payments against the foreign jurisdiction’s income tax (i.e., not subject to tax abroad) • Royalties and interest are direct earnings of the U.S. parent corporation from its own operations, whereas dividends represent earnings of the CFC

  20. Bringing Foreign Earnings Back to the U.S. • Royalties and Interest • Worldwide system: • Included in domestic taxable income • Foreign tax credit for any withholding tax • May be offset by excess credits from repatriated dividends (Appendix C) • Exemption system: • Included in domestic taxable income • Foreign tax credit for any withholding tax • No excess credits from exempt dividends

  21. Issues Common to Administration of Worldwide & Territorial Systems: Transfer Pricing TransferPricing Issues • Basic principle for allocating income among related parties is the arm’s-length standard (the amount that unrelated parties would pay in a comparable transaction) • Transfer pricing rules* implement the arm’s-length principle • Intangible property – highly mobile, difficult to value *Transfer pricing issues were examined at House Ways & Means hearing on July 22, 2010

  22. Transfer Pricing Example TransferPricing Issues • U.S. Manufacturing Corporation manufactures goods in the U.S. at a cost of $300 • Marketing and selling costs are $200 • The goods are sold to foreign customers at a price of $1,000 • The total profit on the goods sold is $500

  23. Transfer Pricing Example With FTC Limitation

  24. Issues Common to Administration of Worldwide & Territorial Systems: Income Shifting TransferPricing Issues • Multinational companies can choose where to locate mobile activities • Income or high-income generating property located in low-tax jurisdictions • Risk from high-tax to low-tax jurisdictions • contract manufacturing, limited-risk distributors

  25. Income Shifting Example TransferPricing Issues • U.S. Manufacturing Corporation manufactures goods at a cost of $300 • Marketing and selling costs are $200 • The goods are sold to foreign customers at a price of $1,000 • The total profit on the goods sold is $500

  26. Income Shifting Example With FTC Limitation

  27. Income Shifting Implications • Use of low-tax subsidiary for location of profits – profits are not taxed in the U.S. until repatriated (deferral), or are exempt under a territorial regime • Does this reflect the economics of the underlying transaction? • Congress’s answer under present law was to have a deemed subpart F inclusion of income (Appendix D) • Exemption systems have various anti-abuse rules • Blacklists • Exemption only available for treaty partners • Minimum substance or activity required in foreign subsidiary • Meaningful tax requirement in foreign subsidiary

  28. Issues Common to Administration of Worldwide & Territorial Systems: Expense Allocation TransferPricing Issues • Parent incurs expenses related to foreign operations; income from foreign operations is not taxed until repatriated (deferral) or is exempt under territorial regime • Interest • General and administrative costs • Research and development • Expenses for worldwide operations are located in high-tax jurisdictions

  29. Expense Allocation Example TransferPricing Issues • U.S. Manufacturing Corporation manufactures goods at a cost of $300 • Marketing and selling costs are $200 • The goods are sold to foreign customers at a price of $1,000 • Interest expense is $150 • The total profit on the goods sold is $350

  30. Expense Allocation Example With FTC Limitation

  31. Expense Allocation Implications • U.S. expense allocation rules apply for computing foreign-source income for purposes of the foreign tax credit limitation • Exemption systems have various rules • “Haircut” on exemption amount (e.g., dividend exemption is 95%) • Earnings stripping rules

  32. Appendix A: Countries Recently Adopting Dividend Exemption Systems TransferPricing Issues • Japan • 2009: 95% dividend exemption • UK • 2009: 100% dividend exemption • New Zealand • 2009: 100% dividend exemption • Czech Republic • 100% dividend exemption for dividends from EU and certain treaty countries • Iceland • 100% dividend exemption for dividends from EU and countries meeting certain requirements

  33. Foreign Tax Credit Limitation Appendix B: Foreign Tax Credit Limitation • Purpose: to ensure that foreign tax credits do not offset the U.S. tax on U.S.-source income • Taxpayer can claim foreign tax credit only to the extent of U.S. tax liability on its foreign-source income • Excess credits may be carried back one year and forward 10 years • Taxpayer may use foreign tax credit carryover only to the extent the taxpayer has not otherwise reached the foreign tax credit limitation (that is, has excess limitation) in the carryover or carryback year

  34. FTC Limitation Example Appendix B: FTC Limitation Example U.S. Corp $3,000 U.S.-source income Dividend of $500 Controlled Foreign Corporation $1,000 foreign-source income 50% tax rate

  35. Appendix B: Without FTC Limitation Without FTC Limitation

  36. Appendix B: With FTC Limitation With FTC Limitation

  37. Appendix C: Royalty Excess Credit Example Cross-Crediting Example U.S. Corp $3,000 U.S.-source income $1,000 Foreign RoyaltyNo Foreign Tax Dividend of $500 CFC Country X CFC Country Y $1,000 income $500 foreign tax

  38. Appendix C: Foreign Tax Credit With Foreign Tax Credit *General basket FTC limitation is $2,000 x 35% = $700 Tax rate on Country Y royalty income 20% ($200/$1,000)** Worldwide tax on Country X income 50% ($500/%1,000) **Excess credit of $150 from high-tax income is used to offset the U.S. tax of $350 on royalty income

  39. Appendix C: Dividend Exemption With Foreign Tax Credit Tax rate on Country Y royalty income 35% ($350/$1,000) Worldwide tax on Country X income 50% ($500/$1,000) Rate on U.S.-source income 35% ($1,050/3,000)

  40. Example of Foreign Base Company Sales Income Appendix D: Use of Base Company with Subpart F Rules U.S. Manufacturing Corp.: Sales Revenue $ 700 Mfg. Costs (300) Sales Costs (200) Sales Profit $ 200 Sub F Inclusion 300 Taxable Profit $ 500 Tax @ 35% $ 175 U.S. Mfg. Corp $700 Sale of Inventory Deemed Dividend of $300 Haven CFC: Sales Revenue $1,000 Purchase from Parent (700) Taxable Profit $ 300 Tax @ 0% 0 Haven CFC Foreign Customers Worldwide Tax Cost: U.S. Tax $175 Foreign Tax 0 Total Tax $175 After-Tax Profit $325 $1,000 Sale of Inventory

  41. Appendix E: Cross Crediting Example Cross-Crediting Example U.S. Corp $3,000 U.S.-source income Dividend of $500 Dividend of $1,000 CFC Country Y CFC Country X $1,000 Income 50% tax rate $1,000 IncomeNo Foreign Tax

  42. Appendix E: Cross Crediting Example Without FTC Baskets U.S. Tax Return Country X Tax Return Country Y Tax Return *FTC limitation is $2,000 x 35% = $700. Limited to actual tax paid of $500. Foreign rate on foreign-source income 25% ($500/$2,000) Residual U.S. rate on foreign-source income 10% ($200/$2,000) U.S. rate on U.S.-source income 35% ($1,050/$3,000) Overall rate on worldwide income 35% ($1,750/$5,000) Allows high-tax income tax to be cross-credited against low-tax income

  43. FTC Separate Limitation Baskets Appendix E: Cross Crediting Example FTC Separate Limitation Baskets • Purpose: To minimize “cross-crediting” of excess foreign taxes for high-taxed foreign earnings against residual U.S. tax on low-taxed foreign earnings • Foreign tax credit limitation is computed separately for income in two categories: passive and general (or active) • Cross-crediting is permitted for income in the same category from different countries

  44. Appendix E: Cross Crediting Example With FTC Baskets Without FTC Baskets U.S. Tax Return Active Income Foreign Tax Passive Income Foreign Tax *Active FTC limitation is $1,000 x 35% = $350. Passive foreign tax credit limitation is also $350, but no passive basket taxes are available. Foreign rate on foreign-source income 25% ($500/$2,000) Residual U.S. rate on foreign-source income 17.5% ($350/$2,000) U.S. rate on U.S.-source income 35% ($1,050/$3,000) Overall rate on worldwide income 38% ($1,900/$5,000)

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