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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
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
Personal relationship  Country of incorporation or residence
  • Economic relationship  Country in which a business has income producing assets or activities
outbound transactions
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
inbound transactions
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
u s taxation of outbound transactions
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)
u s taxation of inbound transactions
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
computing the foreign tax credit
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]

foreign tax credit limitation 904
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

excess credit vs excess limitation impact of foreign tax rate
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*

excess credit vs excess limitation impact of foreign tax rate continued
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

excess credit vs excess limitation planning issues
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
strategies for eliminating excess credits
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.
cross crediting an example
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

cross crediting example continued
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

904 d separate income limitations or baskets principal features
§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
separate income limitations or baskets
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
form 1118 foreign tax credit
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
dividend repatriations from a foreign corporation to a u s parent tax consequences
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)
the deemed paid credit an addition to the actual withholding tax paid
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)
pooling approach of 902 a
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)

ftcl basketing rules of 904 d
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
mechanics of cfc look through rule
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

deemed paid credit lower tier corporations continued
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
dividend repatriations planning
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
earnings stripping an example
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)

earnings stripping example continued
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)
importance of sourcing rules
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
maximizing the foreign tax credit limitation 904
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

overview of the sourcing process
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.
sourcing rules the general rules 861 862
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
sourcing rules the general rules continued
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))
sourcing rules for inventory
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.
50 50 method for sourcing sales
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
50 50 method the property factor
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.
sourcing gross income under 861 some important exceptions
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..
862 income sourced outside the united states
§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
source rules for deductions treasury reg 1 861 8 step 1
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
source rules for deductions treasury reg 1 861 8 step 2
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
special apportionment rules
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)
special apportionment rules continued
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)
source rules for interest expense
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
worldwide effective tax rate why it is important
Worldwide Effective Tax Rate—Why It is Important
  • Impact reported earnings
  • Impacts cash flow
  • Impacts evaluation of tax director
examples of impact of foreign operations on effective tax rates
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%

planning for foreign operations by a u s domestic corporation
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
taking advantage of deferral continued
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
operating in high foreign tax countries continued
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
example continued commissionaire
Example (continued)--Commissionaire
  • Activities
    • Acts as agent for undisclosed principal, Worldco

(contract is between commissionaire and customer)

    • Worldco retains title until it passes to customer
    • Worldco finances receivables and bears credit risk
    • Marketing intangibles remain with Worldco
  • Tax consequences
    • Commissionaire’s income reduced commensurate with reduced responsibilities and risks
    • Commissionaire’s income determined using cost-plus approach
    • Commissionaire does not create a permanent establishment for Worldco
example continued contract manufacturer
Example (continued)—Contract Manufacturer
  • Activities
    • Processes component materials into finished products under contract with Worldco
    • Worldco retains title to inventory
    • Profit and loss risk remains with Worldco
    • Manufacturing intangibles remain with Worldco
  • Tax consequences
    • Contract manufacturer’s income reduced commensurate with reduced responsibilities and risks
    • Contract manufacturer’s income determined using cost-plus approach
    • Contract manufacturer does not create a permanent establishment for Worldco
foreign tax reduction planning holding companies example
Foreign Tax Reduction Planning—Holding Companies (Example)
  • Assume
    • U.S. parent corporation
    • R.S.A. subsidiary
    • Dutch holding company
    • R.S.A. makes dividend distribution to U.S. parent
  • Without the Dutch Holding Company
    • The R.S.A. dividend subject to 25% withholding tax.
  • Dutch Holding Company
    • The R.S.A. dividend subject to 5% withholding tax.
    • The Dutch holding company dividend is subject to an additional 5% withholding tax.
foreign tax reduction planning earnings stripping
Foreign Tax Reduction Planning—Earnings Stripping
  • Debt financing for foreign subsidiaries
    • Interest expense deduction in host country
    • Possible reduction in foreign withholding taxes
    • Possible increase in foreign tax credit limitation

(subject to CFC netting rule)

  • Transfer pricing and technology charges
    • Inventory sales
    • Technology charges
    • Management fees
foreign tax reduction planning incentives in local tax laws
Foreign Tax Reduction Planning—Incentives in Local Tax Laws

Examples

  • Ireland—10% rate for manufacturing
  • Singapore—Tax holidays for high-tech companies
  • Puerto Rico—2% to 7% rate for manufacturing
  • Belgium—Special tax breaks for coordination, service and distribution centers
hybrid entities
Hybrid Entities
  • Classification of Foreign Entity
    • Foreign tax purposes, a corporation
    • U.S. tax purposes, a partnership or branch
  • A U.S. tax shelter?
reg 301 7701 the check the box regulations
Reg. 301.7701—The Check-the-Box Regulations
  • Effective date: January 1, 1997
  • Goal: Simplify entity classification
  • New approach:
    • “Per se” corporations (e.g. U.K plc, German AG, French SA, Dutch NV) classified as corporations
    • For all other entities, taxpayers chooses classification via “check-the-box” procedure
  • Benefits: Enhances ability to use branches and partnerships in international tax planning
tax benefits of a hybrid entity
Tax Benefits of a Hybrid Entity
  • Avoids 10/50 company basket problems
  • Allows flow-through of foreign losses, subject to dual consolidated loss limitations
  • Allows flow-through of foreign tax credits to S corporation or partnership shareholders, a direct §901 foreign tax credit
  • Solves §902 multiple tier problems
  • Avoids Subpart F through the use of “super” holding companies and interest transfers from high tax country hybrid to a low tax country finance country hybrid
  • What is the next frontier of effective tax planning?
what is transfer pricing continued
What is Transfer Pricing--Continued
  • Houseware Distributors, Inc (Parent) must set an appropriate transfer price for the sale of the grill protectors to Houseware Distributors, Pty. (the Japanese subsidiary).
  • Group profit = $25 ($100 - $60 - $15)
  • Impact of alternative transfer prices:
    • Transfer price of $ 60 would allocate entire $25 profit to foreign subsidiary
    • Transfer price of $ 85 would allocate entire profit to U.S. parent
    • Transfer price between $ 60 and $ 85 splits the profit between the U.S. parent and the foreign subsidiary.
slide62
§ 482
  • Goal: Clearly reflect income of affiliated corporations engaged in inter-company transactions.
  • Standard: Arm’s-length price (or market value) standard for evaluating transfer prices
  • Practical difficulty: Market values are highly judgmental and depend on the facts and circumstances.
  • Result: Transfer pricing is the most contentious area of audit and litigation controversy in international taxation.
  • Other observations: Many of the larger states have similar provisions to § 482.
slide63
Principal Factors for Assessing Comparability of Controlled and Uncontrolled Transactions—Reg. 1.482-1
  • Functions performed by the parties involved
  • Contractual terms governing transaction
  • Risks assumed by each party
  • Economic or market conditions in which parties conduct business
  • Nature of property or services transferred in transaction
transfer of intangibles reg 1 482 4 continued
Transfer of Intangibles(Reg. 1.482-4)--Continued
  • ProblemNo comparables due to uniqueness of intangibles
  • Congressional responseCommensuratewith income requirement
  • Pricing methodsComparableuncontrolled transaction method

Comparableprofits method

Profit split method

comparable profits method reg 1 482 5
Comparable Profits Method (Reg. 1.482-5)
  • Determine which affiliate will be the tested party.
  • Obtain data regarding comparable uncontrolled parties.
  • Choose profit level indicator, such as operating profit/sales or operating profit/operating assets.
  • Construct arm’s length range of comparable profits for tested party
  • Make adjustment if reported profit lies outside arm’s length range.
662 e transfer pricing penalties
§662(e) Transfer Pricing Penalties
  • Rationale
    • Promote more voluntary compliance with arm’s length standard
    • Promote better documentation of transfer pricing policies
  • 20% penalty applies if:
    • Transfer price  200% (or  50%) of arm’s length price (“transactional penalty”), or
    • Net §482 adjustment > either $ 5 million or 10% of gross receipts (“net adjustment penalty”)
662 e transfer pricing penalties continued
§662(e) Transfer Pricing Penalties--Continued
  • 40% penalty applies if:
    • Transfer price  400% (or  25%) of arm’s length price, or
    • Net §482 adjustment > either $ 20 million or 20% of gross receipts
  • Reasonable cause exception
    • To avoid net adjustment penalty, taxpayer must have created “contemporaneous” documentation
  • DHL Corporation, TC Memo 1998-481
    • IRS’s imposition of §6662 penalty upheld in court
how should taxpayers respond
How Should Taxpayers Respond?
  • Develop documentation that supports methodology and results
  • Principal documents (§ 1.6662-6)
    • Nature of business
    • Economic and legal environment
    • Organizational structure
    • Controlled transactions
    • Pricing methods selected, rationale
    • Comparables used
    • Economic analysis and projections
  • Assess risk of transfer pricing adjustment
    • Dollar magnitude of inter-company transactions
    • Percentage of worldwide profits attributed to low-tax foreign subsidiaries
  • Consider transfer pricing study or Advance Pricing Arrangement
review u s taxation of foreign subsidiaries
Review—U.S. Taxation of Foreign Subsidiaries

Tax Jurisdiction

  • Excluded from U.S. consolidated return, can [by election] include Canadian and Mexican corporations in the group
  • Taxed only on U.S. source income

Profit Reparations

  • U.S. parent can not claim the dividend received deduction
  • U.S. parent can claim a §902 credit
  • FTCL basketing rules: 10/50 company or CFC look-through rule

Transfer Pricing

  • Must use arm’s-length prices.
anti deferral provisions
Anti-Deferral Provisions
  • Concept
    • Deny deferral of “tainted” foreign earnings
    • Simultaneously allow deferral for active foreign business profits
  • Specific regimes
    • Foreign Personal Holding Companies (enacted in 1937, “pocket book overseas”)
    • Subpart F (enacted in 1962)
    • Passive Foreign Investment Company (enacted in 1986), discourages investment in foreign mutual fund companies
subpart f 951 964 controlled foreign corporations
Subpart F (§§951-964), Controlled Foreign Corporations
  • CFC defined
    • U.S. shareholders own >50% of stock, by vote or value
    • U.S. shareholder is a U.S. person that owns 10% or more of stock
  • Subpart F inclusion (deemed dividend)
    • Subpart F income
    • Investments in U.S. property
subpart f income 951 964
Subpart F Income (§§951-964)
  • FTCL basket is determined by the type of income earned by the subsidiary
  • Foreign base company sales income
    • Income from the sale of goods
    • Goods are purchased from or sold to a related person
    • CFC neither manufactures the product or sells it for sells it for use in CFC’s country of incorporation. CFC can buy in or sell in country of incorporation and can also elect out of Subpart F in high tax jurisdictions.
  • Foreign base company services income
    • Fees for services performed outside CFC’s country of incorporation for a related person.
  • Insurance income
    • Income from insuring risks outside the CFC’s country of incorporation (i.e. lower risks)
  • Foreign personal holding income
    • Passive investment income such as dividends, interest, rents, royalties and capital gains
  • Foreign base company shipping income
  • Foreign base company oil-related income
taxation of u s shareholders
Taxation of U.S. Shareholders

U.S. Shareholders Receive a “Deemed Dividend” from the Controlled Foreign Corporation

  • Year in which CFC has Subpart F Income
    • U.S. shareholder is taxed on deemed dividend (§951)
    • U.S. shareholder can claim §902 credit (§960)
    • FTCL basketing rule: Same character as underlying Subpart F income
  • Actual dividend distributions in subsequent years (§959)
    • Traced first to CFC’s “previously taxed income” (PTI)
    • Receipt of PTI is a tax- free return of capital
earnings invested in u s property by the controlled foreign corporation 956
Earnings Invested in U.S. Property bythe Controlled Foreign Corporation (§956)
  • Concept: Constructive dividend of active foreign business profits
  • Treatment: Current inclusion under Subpart F
  • Transactions triggering §956 inclusions
    • CFC makes loan to U.S. shareholders (includes guarantees)
    • CFC purchases stock issued by U.S. shareholders
    • CFC purchases tangible property located in U.S.
    • CFC purchases right to use intangible property is U.S.
form 5471 information return of a u s person with respect to a cfc
Form 5471 Information Return of a U.S. Person with Respect to a CFC
  • Who must file
    • Shareholder of CFC
  • Contents
    • Sch. A – Stock of CFC
    • Sch. B – U.S. shareholders
    • Sch. C and F – Financial statements
    • Sch E, H and J – Foreign taxes and E&P
    • Sch. I – Subpart F income
    • Sch M – Inter-company transactions
    • Sch. O – Changes in stock ownership
  • $ 10,000 penalty for failure to file
  • TRA of 1997 added similar reporting requirements for foreign partnerships controlled by U.S. persons
foreign personal holding company 551 558
Foreign Personal Holding Company (§§551-558)
  • Concept: Incorporated pocketbook of wealthy U.S. citizens
  • Definition of FPHC
    • 5 or fewer U.S. citizens own 50% or more of stock
    • 60% or more of gross income is FPHC income
  • Deemed Dividend = Undistributed FPHC income
passive foreign investment company 1291 1298
Passive Foreign Investment Company (§§1291-1298)
  • PFIC defined:
    • 75% or more of gross income is passive investment income or
    • 50% or more of assets produce passive income
  • Taxation of U.S. shareholders
    • Qualified Electing Fund electionCurrent taxation or
    • Excess distribution: Pay deferred tax + interest
review subchapter c non recognition provisions
Review—Subchapter C Non-recognition Provisions
  • Concept
    • Tax-free treatment of changes in legal form, but not the underlying substance, of an investment
    • Any appreciation not taxed currently is preserved for taxation in the future through carryover basis
  • Non-recognition Transactions
    • Incorporations (§351): Transfers of appreciated property to a controlled corporation
    • Subsidiary liquidations (§332): Transfer of appreciated property to parent corporation in complete liquidation
    • Reorganizations (§368 (a)(1)(A) and (a)(1)(D): Acquisitive (e.g., merger) and divisive (e.g., spin-off)
illustration of tax avoidance opportunities created by outbound transfers to foreign corporations
Illustration of Tax Avoidance Opportunities Created by Outbound Transfers to Foreign Corporations
deemed sale regime of 367 a
Deemed Sale Regime of §367 (a)

U.S. parent transfers appreciated property to a foreign subsidiary corporation. Results is an outbound toll charge include on the parent’s U.S. income tax return.

  • Impact of §367(a): Recast tax-free transfers as taxable sales
  • Exception: Assets used in active foreign business (§367(a)(3)(A))
  • Exception does not apply to
    • Inventory, receivables, currency and intangibles (§367 (a)(3)(B))
    • Foreign branch with previously deducted losses (§367 (a)(3)(C))
    • To the extent of depreciation recapture on U.S. assets only (Reg. 1.367(a)-4T(b))
  • Reporting requirement: Form 926
deemed royalty regime of 367 d
Deemed Royalty Regime of §367(d)

U.S. parent transfers a patent to a foreign subsidiary, and receives a “deemed royalty”

“Deemed” ActualTax AttributeRoyaltyRoyalty

  • Commensurate with income requirement Yes Yes
  • Foreign source income Yes Yes
  • Foreign tax deduction No Yes
  • Foreign withholding taxes No Yes

(treaties, however, often provide exemption)

illustration of tax avoidance opportunities created by inbound liquidation of cfc
Illustration of Tax Avoidance Opportunities Created by Inbound Liquidation of CFC
  • Facts
    • CFC distributes its accumulated E & P to USP in liquidation
  • U.S. tax consequences, ignoring §367
    • CFC’s earnings were not taxed currently (deferral privilege)
    • USP’s receipt of the distribution is tax free under §332
    • Any residual U.S. tax is permanently avoided
deemed dividend regime of 367 b
Deemed Dividend Regime of §367(b)
  • As a result of the CFC liquidation the U.S.Parent

will pay an inbound toll charge on its U.S. tax return.

  • Bad news:
    • USP must include in income the lesser of

(a) Dividend = CFC’s accumulated E & P

(b) Capital gain = MV of distribution – USP’s basis in stock

  • Good news:
    • USP can obtain §902 credit with respect to any dividend income
other non recognition transactions subject to a toll charge
Other Non-recognition Transactions Subject to a Toll Charge

U.S. corporation transfers appreciated

property to a foreign entity.

  • Outbound transfers to non-corporate entities
    • TRA 1997 added §721(c): Transfers to partnerships with foreign partners
    • Also added §684: Transfers to foreign estates and trusts
  • Expatriating liquidation of U.S. subsidiary into foreign parent
  • Other inbound and foreign-to-foreign transfers involving CFC’s
overview of inbound transactions
Overview of Inbound Transactions

A foreign corporation invests in U.S. assets

and receives U.S. source income.

  • General Rules
    • Withholding tax regime for U.S. source non-business income (or “FDAP” (fixed or determinable, annual or periodic) [e.g. interest, dividends, rents, and royalties but not capital gains]
    • Net basis taxation on U.S. source business profits or “ ECI ” (effectively connected income)
  • Special Rules
    • Treaty exemptions and reductions (e.g. UK 5% dividends, 0% interest and royalties
    • Anti-earnings stripping rules (§163(j))
    • U.S. real property interests (§897)
    • Branch profits tax (§884)
u s taxation of non business income
U.S. Taxation of Non-Business Income
  • General Rules
    • Base = Gross amount of U.S. source income
    • Statutory rate = 30%
    • Collection via withholding by U.S. payer
  • Exceptions
    • Capital gains
    • Portfolio interest income (10%+ shareholders excluded)
    • U.S. real property interest
    • Treaty withholding rates
  • W8 BEN available for non-resident aliens
repatriating profits from domestic subsidiaries
Repatriating Profits from Domestic Subsidiaries
  • Goal: to minimize U.S. taxes (subsidiary-level and shareholder-level, and foreign taxes)
  • From the U.S. subsidiary perspective
    • The issue is whether the remittance to the foreign parent corporation creates a U.S. tax deduction
  • From the foreign parent perspective
    • What is the U.S. withholding tax rate on the remittance?
    • Are foreign taxes owed on the remittance?
163 j anti earnings stripping provisions
§163(j)--Anti-Earnings Stripping Provisions
  • §163(j) applies to U.S. subsidiaries that have:
    • Debt to equity ratio in excess of 1.5 to 1
    • “Disqualified interest” payments, and
    • “Excess interest” expense
  • Definition of “disqualified interest”
    • Interest paid to a related party and exempt from U.S. tax (or subject to reduced withholding tax rate)
    • Interest paid to unrelated party (e.g. U.S. bank), but guaranteed by related party (e.g. foreign parent) and exempt from U.S. withholding tax
anti earnings stripping provisions continued
Anti-Earnings Stripping Provisions (Continued)
  • Disallowed interest expense deductions are limited to the amount of excess interest
  • Definition of “excess interest”
    • Net interest expense – 50% (adjusted taxable income)
    • Net interest expense = interest expense – interest income
    • Adjusted taxable income = Taxable income

+ Net interest expense

+ NOL carryovers

+ Depreciation expense

+/- Changes in receivables and payables

  • “Excess interest” is a cash flow concept
  • Indefinite carry-forward of disallowed interest expense deductions
planning for section 163 j
Planning for Section 163 (j)
  • Remove foreign parent’s guarantee
  • Reduce U.S. subsidiary’s debt-to-equity ratio below 1.5 to 1
  • Increase U.S. subsidiary’s “adjusted taxable income” without increasing taxable income
  • U.S. subsidiary should buy assets rather than leasing them.
form 5472 information return of a foreign owned u s corporation
Form 5472: Information Return of a Foreign-Owned U.S. Corporation
  • Who must file
    • 25% foreign-owned domestic corporation
    • Foreign corporation engaged in U.S. trade or business
  • Contents
    • 25% foreign subsidiaries
    • Other related parties
    • Transactions with foreign related parties
  • Record maintenance requirements
  • $ 10,000 annual penalty
taxation of u s real property interests
Taxation of U.S. Real Property Interests
  • For foreign investors, gains on sale of U.S. real property interests are taxed like effectively connected income.

(§897)

  • U.S. real property interests include:
    • Land and buildings
    • Mines, wells and other natural deposits
    • Growing crops and timber
    • Personal property “associated with” use of real property such as fences and moveable equipment
u s real property interests continued
U.S. Real Property Interests (Continued)
  • Foreign investors become shareholders in a U.S. domestic corporation which invests in U.S. real property.
  • U.S. real property holding corporations
    • Market value of U.S. real property holdings  50% of market value of all real property and business interests
  • Purchasers of U.S. real property interests
    • Obligation to withhold 10% U.S. tax on amount realized by foreign seller.
u s taxation of inbound transactions1
U.S. Taxation of Inbound Transactions

A foreign corporation receives ECI and/or

FDAP

  • Two-pronged system for taxing foreign persons
    • Passive foreign investors: Gross basis withholding tax
    • U.S. branch operations: Net basis on ECI
  • Focus here is on U.S. branch operations
foreign corporation engaged in a u s trade or business
Foreign Corporation Engaged in a U.S. Trade or Business
  • Nexus
    • Per IRC: “Trade or business” within U.S.
    • Per Treaty: “Permanent establishment” within U.S.
  • Tax base: Effectively connected income (§864(c))
    • U.S. source business income
    • Selected types of foreign source business income
    • Selected types of U.S. source non-business income
    • Look back rules (10 years under §864(c)(7)
  • Tax rate schedule: same as domestic corporation
884 the branch profits tax rationale
§884—The Branch Profits Tax—Rationale

Goal: Mimic U.S. withholding tax on dividends paid by U.S. subsidiaries (Comparison of # 1 with # 2)

  • The U.S. subsidiary pays the corporate level U.S. income tax and remits a dividend to the Foreign parent corporation. The dividend is subject to U.S. withholding tax at the shareholder level.
  • The U.S. branch pays the corporate level U.S. income tax and remits a dividend equivalent amount to the Foreign parent corporation. The dividend equivalent amount is subject to the branch profits tax.
computing the branch profits tax
Computing the Branch Profits Tax
  • Need formula for estimating dividend equivalent amount
  • Under §884 (b)
    • Effectively connected E & P for the year
    • + Decrease in “ U.S. net equity”

(deemed distribution to foreign home office)

or

- Increase in “U.S. net equity”

(deemed reinvestment in U.S. branch)

= Dividend equivalent amount

  • Tax rate = 30% statutory rate subject to treaty reductions
    • Some Treaties eliminate the amount
branch profits tax an example year 1
Branch Profits Tax– An Example (Year 1)

Year 1

  • Treaty rate on dividends (controlling shareholder) = 5 %
  • Effectively connected E & P = $ 100
  • U.S. net equity: $1,000 at beginning of year

$1,100 at end of year

  • Branch profits tax calculation:

Effectively connected E & P $ 100

Increase in U.S. net equity:

Beginning of year $ 1,100

End of year 1,100 (100)

Dividend equivalent amount $ 0

x 5%

Branch profits tax $ 0

branch profits tax an example year 2
Branch Profits Tax: An Example (Year 2)

Year 2

  • Treaty rate on dividends (controlling shareholder) = 5 %
  • Effectively connected E & P = $ 100
  • U.S. net equity: $1,000 at beginning of year

$1,100 at end of year

  • Branch profits tax calculation:

Effectively connected E & P $ 0

Decrease in U.S. net equity:

Beginning of year $ 1,100

End of year 1,06040

Dividend equivalent amount $ 40

x 5%

Branch profits tax $ 2

884 f branch interest withholding tax
§884 (f)—Branch Interest Withholding Tax

What is it?

  • 30% withholding tax on “interest payments”
  • Tax imposed on foreign payee, not the U.S. branch
  • Creates tax parity between U.S. tax imposed on interest payments made by U.S. branches and U.S. subsidiaries

Computation of tax:

  • Reg. 1.884-4 defined “interest payment”
  • Statutory exemptions (e.g. portfolio interest exemption) and reduced withholding rates apply
884 f an additional provision the excess interest tax
§884(f)--An Additional Provision, The Excess Interest Tax

What is it?

  • 30% tax on U.S. branch’s excess interest
  • Tax is imposed on U.S. branch, not the recipient of the interest payment
  • Recapture provision designed to create symmetry between interest deductions and related interest income inclusions

Computation of tax:

  • Excess interest = Interest expense deducted in computing “Effectively Connected Income” (per §1.882 -5)

minus

“Interest payments” subject to branch interest withholding tax [See Preceding

slide]

  • Reduced treaty withholding rates apply
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