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Chapter 9

Chapter 9. Taxation of International Transactions. 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.

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Chapter 9

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  1. Chapter 9 Taxation of International Transactions

  2. 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

  3. 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

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

  5. 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

  6. 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

  7. 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

  8. 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

  9. 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

  10. 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

  11. 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

  12. 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

  13. 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

  14. 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

  15. 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

  16. 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

  17. 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

  18. 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

  19. 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

  20. 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

  21. Transfer Pricing Example (slide 1 of 2)

  22. Transfer Pricing Example (slide 2 of 2)

  23. 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

  24. 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

  25. 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

  26. 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

  27. 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

  28. 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

  29. 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

  30. 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

  31. 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

  32. 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

  33. 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

  34. 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

  35. 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

  36. 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

  37. 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

  38. 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

  39. 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

  40. 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

  41. 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

  42. 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

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

  44. Foreign Tax Credit • Foreign tax credit (FTC) provisions are designed to reduce the possibility of double taxation • Allows a credit for foreign income taxes paid • Credit is a dollar-for-dollar reduction of U.S. income tax liability • FTC may be “direct” or “indirect” • The FTC is elective • May take a deduction for foreign taxes paid or incurred rather than the FTC

  45. Direct Foreign Tax Credit • Available to taxpayers who pay or incur a foreign income tax • Only person who bears the legal burden of the foreign tax is eligible for the direct credit • Direct credit is not available to a U.S. corporation operating in a foreign country through a foreign subsidiary

  46. Indirect Foreign Tax Credit (slide 1 of 5) • The indirect credit is available to U.S. corporations for dividends received (actual or constructive) from foreign corporations • Foreign corp pays tax in foreign jurisdiction • When foreign corp remits dividends to U.S. corp, the income is subject to tax in the U.S.

  47. Indirect Foreign Tax Credit (slide 2 of 5) • Foreign taxes are deemed paid by U.S. corporate shareholders in same proportion as dividends bear to foreign corp’s post-1986 undistributed E & P • Indirect FTC = Actual or constructive dividend X Post-1986 foreign taxes Post-1986 undistributed E & P • Corporations choosing the FTC for deemed-paid foreign taxes must gross up dividend income by the amount of deemed-paid taxes

  48. Indirect Foreign Tax Credit (slide 3 of 5) • Example • Wren Inc, a domestic corp, receives a $120,000 dividend from Finch Inc, a foreign corp. Finch paid $500,000 of foreign taxes on post-1986 E & P totaling $1,200,000 (after taxes)

  49. Example (cont’d)—Wren’s deemed-paid foreign taxes for FTC purposes are $50,000 Cash dividend from Finch $120,000 Deemed-paid foreign taxes $500,000 × $ 120,000 50,000 $1,200,000 Gross income to Wren $170,000 Wren must include $50,000 in gross income for the gross up adjustment if FTC is elected Indirect Foreign Tax Credit (slide 4 of 5)

  50. Indirect Foreign Tax Credit (slide 5 of 5) • Only available if domestic corp owns 10% or more of voting stock of foreign corp • Credit is available for 2nd and 3rd tier foreign corps if 10% ownership requirement is met • Credit is also available for 4th through 6th tier foreign corps if additional requirements are met

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