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Principles of Taxation

Principles of Taxation. Chapter 12 Jurisdictional Issues in Business Taxation. Jurisdictional Issues. Nexus - the right to tax Apportionment Permanent establishment in foreign country Worldwide taxation and foreign tax credits Blending high and low tax income Branch versus subsidiary

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Principles of Taxation

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  1. Principles of Taxation Chapter 12 Jurisdictional Issues in Business Taxation

  2. Jurisdictional Issues • Nexus - the right to tax • Apportionment • Permanent establishment in foreign country • Worldwide taxation and foreign tax credits • Blending high and low tax income • Branch versus subsidiary • Preventing abuse: Subpart F and transfer pricing

  3. State and Local Tax • Taxation requires nexus - degree of contact between business and state. • Having nexus in the state where incorporated is due to ___________ domicile. • What creates physical presence nexus? • Economic nexus: regular commercial activity - law still unclear. • Other issues: Catalog sales, internet sales.

  4. Apportionment of State Income • How to determine State X’s share of Corporation C’s taxable income? • Under UDIPTA model, apportion based on factor weights: • About 1/2 of the state double-weight _______. Does this favor or hurt in-state businesses?

  5. International Business Transactions - Jurisdiction • Tax treaties govern the jurisdiction to tax as well as exceptions related to tax rates. • Business activities are taxed by country of residence (incorporation) unless the firm maintains a______________ ______________. • Fixed location, such as an office of factory, with regular commercial operations. • Typically does not result from mere exporting.

  6. International Jurisdiction - Continued • Double taxation may result from two jurisdictions claiming right to tax the same income. • U.S. taxes the _______________income of its resident taxpayers (e.g., corporations legally incorporated in the United States). • If the U.S. corporation has a branch that is doing business as a permanent establishment, who gets to tax the branch? • What relief exists for double taxation?

  7. The Foreign Tax Credit • In the U.S. (and other major trading partners), the relief comes from a foreign tax credit. • Applies only to what kind of taxes? • Reduce U.S. taxes by foreign income taxes paid. • These rules are extremely complex, but this chapter teaches the basics.

  8. Foreign Tax Credit Limitation • The U.S. will only grant a credit up to the U.S. tax rate X foreign source taxable income. • Equivalently, FTC limit = ________tax X ________ income / _________income. Why are these equivalent? • If the firm has paid more foreign tax than the FTC limit, ___year carryback, ____ year carryforward.

  9. FTC Planning • Firms can cross-credit between high- and low-tax rate country income. • Without cross-crediting, here’s the problem: • Pay tax on income in Japan branch at 50% of $100, only claim $_____ FTC. • Pay tax on income in Ireland branch at 10% of $100, only claim $_____ FTC. • Total U.S. tax on $200 x 35% = $__________ - $_____ FTC = $25 U.S. tax paid + $_____ foreign tax paid = $85 total worldwide tax burden.

  10. FTC Planning – Cross-Credit • With cross-credit, you combine all similar type foreign source income to compute limitation: • FTC limit = $70 US tax X $200 foreign income / $200 worldwide income = $________. • Total U.S. tax on $200 x 35% = $70 - $_____ actual foreign taxes paid = $____ U.S. tax paid + $____ foreign tax paid = $_____ total worldwide tax.

  11. FTC for Alternative Minimum Tax • FTC has an additional limit for AMT purposes. • FTC cannot exceed ______% of tentative minimum tax.

  12. Organizational Forms - Direct Taxation • FSC - a ‘paper’ entity incorporated overseas that qualifies the U.S. parent for special tax exemption on export sales. • Foreign branch or partnership - the U.S. corporation is fully taxed on branch or (share of) partnership income. • The U.S. corporation has a direct foreign tax credit for income taxes paid by branch or partnership. • The export operation, branch or partnership may be owned by any entity in the domestic group: e.g. by a U.S. headquarters corporation or by a separate domestic subsidiary created by that purpose.

  13. Organizational Forms - Foreign Subsidiary • Can a foreign sub be part of the consolidated U.S. return? • When does the U.S. generally get to tax income earned by foreign subs? • When a dividend is repatriated out of after-tax earnings: • the dividend is foreign source earnings. • the dividend is “grossed-up.” What does this mean? • the associated tax generates a “deemed-paid” foreign tax credit.

  14. Deemed-Paid Credit Example • USCo pays tax at 35%. UKSub pays tax at 40%. • UKSub earns $100 pretax, pays tax of $40 and has after-tax earnings of $60. • If UKSub pays a dividend of all the after-tax earnings of $60, the dividend is “grossed-up” to the pre-tax amount of $100. • USCo has $100 of foreign source income, but may claim a FTC of $____ subject to the FTC limitation. • If this is the only foreign source income, USCo would be limited to $____ of FTC.

  15. Deferral of U.S. Tax • Because foreign subsidiary income is not taxed in the U.S. until repatriated, large tax savings result from earning income in low-tax countries and delaying repatriation. • U.S. tax is deferred until repatriation. • Under U.S. GAAP (APB Opinion 23), firms can avoid recording deferred tax if they state that the earnings are “permanently reinvested.”

  16. Deferral Creates Incentives for Tax Avoidance • Tax deferral creates incentives to shift income artificially into low-rate countries (“tax havens”). Examples: • Place cash in Bermuda subsidiary bank account - earn interest tax-free. • Sell goods at low prices to Cayman Islands; resell at high prices to foreign customers - earn tax-free profit. • U.S. law prevents above abuses. Subpart F income (like examples above) earned by controlled foreign corporations is taxable immediately.

  17. Transfer Pricing • Where SubpartF rules do not apply, firms can engage in some shifting between entities through transfer prices. Examples: • Pay royalties from high-tax entities to low-tax entities. • Charge higher prices to high-tax entities for goods and services. • Pay management fees from high-tax entities to low-tax entities. • IRS has broad powers under IRC Section 482 to reallocate income to correct unrealistic prices.

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