Chapter 13 Multijurisdictional Taxation
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.
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?
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 controlled foreign corporation (CFC). 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 CFC? Read the chapter and formulate your response.
U.S. International Tax Provisions(slide 1 of 2) Concerned primarily with two types of potential taxpayers: U.S. persons earning income from outside the United States, and Non-U.S. persons earning income from inside the United States 5
U.S. International Tax Provisions(slide 2 of 2) • 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
Sources of Law(slide 1 of 3) • U.S. individuals and companies • Subject to both U.S. law and laws of other jurisdictions in which they operate or invest • The Internal Revenue Code addresses the tax consequences of earning income anywhere in the world • Must also comply with the local tax law of the other nations in which they operate • For non-U.S. persons, U.S. statutory law is relevant to income they earn that is connected to U.S. income-producing activities
Sources of Law(slide 2 of 3) • Tax treaties exist between the U.S. and many other countries • All tax treaties are organized in the same way • Include provisions regarding the taxation of: • Investment income • Business profits from a permanent establishment (PE) • Personal service income, and • Exceptions for certain persons (e.g., athletes, entertainers, students, and teachers)
Sources of Law(slide 3 of 3) • Tax treaty provisions generally override the treatment otherwise called for under the Internal Revenue Code or foreign tax statutes
Authority to Tax(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
Authority to Tax(slide 2 of 2) • Foreign persons may be subject to tax in the U.S. • Generally, subject to tax only on income earned within U.S. borders
Sourcing of Income • Determining the source of income is critical in calculating the U.S. tax consequences to both U.S. and foreign persons • Numerous tax provisions address the income-sourcing rules for all types of income • These sourcing rules generally assign income to a geographic source based on the location where the economic activity producing the income took place
The Big Picture – Example 8Income Sourcing (slide 1 of 2) Return to the facts of The Big Picture on p. 13-2. Assume that VoiceCo makes an overseas investment and generates $2 million of gross income and a $50,000 expense, all related to real estate sales and rental activities. The expense is allocated and apportioned using gross income as a basis.
Allocation and Apportionment of Deductions (slide 1 of 2) • 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 to which they directly relate • Then, deductions are apportioned between statutory and residual groupings
Allocation and Apportionment of Deductions (slide 2 of 2) • Interest expense is 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
The Big Picture – Example 9Apportionment Of Interest Expense Return to the facts of The Big Picture on p. 13-2. 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
Foreign Tax Credit • Foreign tax credit (FTC) provisions are designed to reduce the possibility of double taxation • Allows a credit for foreign 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 for any particular tax year • If FTC is not elected, § 164 allows a deduction for foreign taxes paid or incurred • Cannot take a credit and deduction for same foreign taxes • In most situations the FTC is more valuable to the taxpayer
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
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.
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
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)
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)
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 at the 2nd and 3rd levels • Credit is also available for 4th through 6th tier foreign corps if additional requirements are met
Limit is designed to prevent foreign taxes from being credited against U.S. taxes on U.S.-source taxable income FTC cannot exceed the lesser of: Actual foreign taxes paid or accrued, or U.S. taxes (before FTC) on foreign-source taxable income, calculated as follows: U.S. tax × Foreign-source taxable income before FTC Worldwide taxable income Foreign Tax Credit Limitations (slide 1 of 3)
Foreign Tax Credit Limitations (slide 2 of 3) • Limitation can prevent total amount of foreign taxes paid in high-tax jurisdictions from being credited • Generating additional foreign-source income in low, or no, tax jurisdictions could alleviate this problem • However, a separate limitation must be calculated for certain categories (baskets) of foreign source income
Foreign Tax Credit Limitations (slide 3 of 3) • For tax years beginning after 2006, there are only two baskets: • Passive income, and • All other (general) • Any FTC carryforwards into post-2006 years are assigned to one of these two categories
The Big Picture – Example 14Foreign Tax Credit Limit (slide 1 of 2) Return to the facts of The Big Picture on p. 13-2. Assume that VoiceCo invests in the bonds of non-U.S. corporations. VoiceCo’s worldwide taxable income for the tax year is $1,200,000, consisting of $1,000,000 of profits from U.S. sales, and $200,000 of interest income from foreign sources. All of the foreign income is in the passive basket. Foreign taxes of $90,000 were withheld by tax authorities on these interest payments.
The Big Picture – Example 14Foreign Tax Credit Limit (slide 2 of 2) VoiceCo’s U.S. tax before the FTC is $420,000 $1,200,000 X 35%. Its FTC is limited to $70,000. $420,000 X ($200,000/$1,200,000). Thus, VoiceCo’s net U.S. tax liability on this income is $350,000 after allowing the $70,000 FTC. The remaining $20,000($90,000 foreign tax paid - $70,000 FTC benefit) of foreign taxes may be carried back one year or forward 10 years, for use within the passive basket.
Controlled Foreign Corporations (slide 1 of 3) • Pro rata share of Subpart F income generated by a controlled foreign corporation (CFC) is currently included in income of U.S. shareholders
Controlled Foreign Corporations (slide 2 of 3) • Examples of Subpart F income include: • Passive income such as interest, dividends, rents, and royalties • Sales income where neither the manufacturing activity nor the customer base is in the CFC’s country and either the property supplier or the customer is related to the CFC • Service income where the CFC is providing services on behalf of its U.S. owners outside the CFC’s country
Controlled Foreign Corporations(slide 3 of 3) • 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
Transfer Pricing Example (slide 1 of 3) §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 The IRS can use this power to address perceived abuses, as reflected in the following transfer pricing example. 33
Inbound Issues • Generally, only the U.S.-source income of nonresident alien individuals and foreign corporations is subject to U.S. taxation • A person is treated as a resident of the U.S. for income tax purposes if he or she meets either: • The green card test, or • The substantial presence test • If either test is met, the individual is deemed a U.S. resident for the year • A foreign corp is one that is not domestic
U.S. Taxation of Nonresident Aliens (slide 1 of 3) • Non-resident alien income not “effectively connected” with U.S. trade or business • Includes dividends, interest, rents, royalties, etc • 30% tax must be withheld by payor of income, unless this rate is reduced by treaty with the payee’s country of residence • No deductions can offset this income
U.S. Taxation of Nonresident Aliens (slide 2 of 3) • Example: German resident earns $1,000 dividend from U.S. corporation • Absent a U.S.-German treaty, $300 U.S. tax is withheld, and the German resident receives $700 • Treaties frequently reduce the withholding rates on dividends and interest • The payor corporation remits the tax to the IRS
U.S. Taxation of Nonresident Aliens (slide 3 of 3) • Non-resident alien income effectively connected with U.S. trade or business • This income is taxed at the same rates that apply to U.S. citizens • Deductions for expenses related to the income may be claimed
State Income Taxation • 46 states and District of Columbia impose a tax based on corp’s taxable income • Majority of states “piggyback” onto Federal income tax base • Essentially, they have adopted part or all of the Federal tax provisions
UDITPA and the Multistate Tax Commission • Uniform Division of Income for Tax Purposes Act (UDITPA) is a model law relating to assignment of income among states for multistate corps • Many states have adopted UDITPA either by joining the Multistate Tax Commission or modeling their laws after UDITPA
Nexus for Income Tax Purposes (slide 1 of 2) • Nexus is the degree of business activity which must be present before a state can impose tax on an out-of-state entity’s income • Sufficient nexus typically exists if: • Income is derived from within state • Property is owned or leased in state • Persons are employed in state • Physical or financial capital is located in state
Nexus for Income Tax Purposes (slide 2 of 2) • No nexus if only “connection” to state is solicitation for sale of tangible personal property, with orders sent outside state for approval and shipping to customer (Public Law 86-272) • Sales tax can still apply
State Modifications (slide 1 of 2) • State modification items come about because each state creates its own tax base • Some of the rules adopted may differ from those used in the Internal Revenue Code • State modification items reflect such differences, for example • The state might allow a different cost recovery schedule • The state might tax interest income from its own bonds or from those of other states
State Modifications (slide 2 of 2) State modification examples (cont’d) The state might allow a deduction for Federal income taxes paid The state might disallow a deduction for payment of its own income taxes The state might allow a net operating loss (NOL) deduction only for losses generated in the state The state’s NOL deduction might reflect different carryover periods than Federal law allows 46
Allocation and Apportionment of Income (slide 1 of 3) • Apportionment is the means by which business income is divided among states in which it conducts business • Corp determines net income for the company as a whole and then apportions some to a given state, according to an approved formula
Allocation and Apportionment of Income (slide 2 of 3) • Allocation is a method used to directly assign specific components of a corp’s income, net of related expenses, to a specific state • Allocable income generally includes: • Income or loss from sale of nonbusiness property • Income or losses from rents or royalties from nonbusiness real or tangible personal property
Allocation and Apportionment of Income (slide 3 of 3) • Typically, allocable income (loss) is removed from corporate net income before the state’s apportionment formula is applied • Nonapportionable income (loss) assigned to a state is then combined with income apportionable to the state to arrive at total income subject to tax in the state
Apportionment Procedure • Business income is assigned to states using an apportionment formula • Business income arises from the regular course of business • Integral part of taxpayer’s regular business • Nonbusiness income is apportioned or allocated to the state in which the income-producing asset is located