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16-1©2008 Prentice Hall, Inc.
©2008 Prentice Hall, Inc. 16-2
U.S. TAX OF FOREIGN-U.S. TAX OF FOREIGN-RELATED TRANSACTIONSRELATED TRANSACTIONS
Jurisdiction to taxTaxation of U.S. citizens &
resident aliensTaxation of nonresident aliensTaxation of U.S. businesses
operating abroadFinancial statement implications
©2008 Prentice Hall, Inc. 16-3
Jurisdiction to TaxJurisdiction to Tax
U.S. authority to tax foreign-related transactions based on three factorsTaxpayer’s country of citizenshipTaxpayer’s country of residenceLocation where the income is
earned
©2008 Prentice Hall, Inc. 16-4
Taxation of U.S. Citizens Taxation of U.S. Citizens and Resident Aliensand Resident Aliens
U.S. citizens and resident aliens taxed on worldwide income
Income earned in foreign countries or U.S. possessions receives special treatment
Foreign tax creditForeign earned exclusion
©2008 Prentice Hall, Inc. 16-5
Foreign Tax Credit (FTC)(1 of 4)
What taxes qualify for FTC?Who is eligible for FTC?How are taxes denominated in foreign
currency translated into dollars?FTC permits U.S. citizens and residents
to avoid double taxationDirectly reduces U.S. tax liability
©2008 Prentice Hall, Inc. 16-6
Foreign Tax Credit (FTC)(2 of 4)
FTC limited to lesser of Foreign tax actually paid OR
foreign taxable income U.S. taxworldwide taxable income x liability
©2008 Prentice Hall, Inc. 16-7
Foreign Tax Credit (FTC)(3 of 4)
FTC deducted after nonrefundable credits
Unused FTC carried back one year and forward ten years on a FIFO basis to a year where taxpayer has an excess credit limitation
Source of income rules on p. C16-6Used to determine numerator of FTC
formula
©2008 Prentice Hall, Inc. 16-8
Foreign Tax Credit (FTC)(4 of 4)
Special FTC limitationNine separate baskets of income
Foreign tax credit calculated for each basket of income
See page C16-6 for partial list of basketsExcess FTC cannot from one basket
cannot offset excess limitation amounts in another basket
©2008 Prentice Hall, Inc. 16-9
Foreign Earned Income Exclusion (FEI) (1 of 5)
FEI available to U.S. citizens and resident aliens working abroad
EligibilityBona fide resident test
Resident of foreign country uninterrupted for entire tax year and maintain tax home in foreign country
©2008 Prentice Hall, Inc. 16-10
Foreign Earned Income Exclusion (FEI) (2 of 5)
Eligibility (continued)Physical presence test
Taxpayer must be physically present in a foreign country for 330 full days during a 12-month period, AND
Maintain a tax home in a foreign country during that period
©2008 Prentice Hall, Inc. 16-11
Foreign Earned Income Exclusion (FEI) (3 of 5)
Foreign earned incomeWages, salaries, & fees as compensation
for personal services actually renderedAmount of exclusion
Lesser of $82,400, ORForeign earned income for current year, OR$225.75 ($82,400/365 days) x no. of
qualifying days in current year
©2008 Prentice Hall, Inc. 16-12
Foreign Earned Income Exclusion (FEI) (4 of 5)
Additional exclusion for taxable housing allowanceLimitation lesser of
Actual housing amount included in income, OR
$13,184 ($36.12) x (qualifying days/365)Housing costs incurred in excess of
$13,184 are a for AGI deduction if not provided by employer
©2008 Prentice Hall, Inc. 16-13
Foreign Earned Income Exclusion (FEI) (5 of 5)
Housing allowance exclusion (continued)Allowance limited to lesser of employer-
provided amount or the individual’s FEIHousing allowance exclusion reduces amount
eligible for FEI exclusionFTC & FEI exclusion are mutually exclusive
Claim either the FTC or the FEI exclusion on foreign earned income, but not both
©2008 Prentice Hall, Inc. 16-14
Taxation of Nonresident Taxation of Nonresident AliensAliens
Resident/nonresident definitionsInvestment incomeTrade or business incomeCalculating US income tax
©2008 Prentice Hall, Inc. 16-15
Resident/Nonresident Definitions
(1 of 2)
Resident aliens are taxed same as U.S. citizens
Nonresident aliens generally taxed only on U.S. source income
Taxpayer is a resident alien if they meet one of the two tests
©2008 Prentice Hall, Inc. 16-16
Resident/Nonresident Definitions
(2 of 2)
Green-card testPermanent resident w/ “green card” visa
Physical presence testPresent 31 days during current calendar
year AND present 183 weighted average days during a three year periodCurrent year: 1 day counted as 1 dayPrior year: 1 day counted as 1/3 day 2nd prior year: 1 day counted as 1/6 day
©2008 Prentice Hall, Inc. 16-17
Investment Income(1 of 2)
Most U.S. source passive or investment income is taxed at 30%30% applied to gross amountU.S. payer must withhold tax
U.S. payer responsible for tax if not withheld
Tax rate often reduced by tax treaties
©2008 Prentice Hall, Inc. 16-18
Investment Income(2 of 2)
Income exempt from U.S. taxationNon-USToB capital gains if individual
physically present < 183 days during yearNon-USToB interest from banks or other
financial institutions not taxedPortfolio interestIncome from casual sale of personal
property
©2008 Prentice Hall, Inc. 16-19
Trade or Business Income
U.S. Trade or business (USToB)Conducting business in US on regular
basis with intent to make a profitIncome exempt from US tax if
In U.S. <90 days/yr, employed by nonresident entity, and earn <$3,000
Real estate income may be treated as USToB instead of passive income
©2008 Prentice Hall, Inc. 16-20
Calculating U.S. Income Tax
Individuals must itemize deductionsCannot claim standard deduction
Normal deductions apply for items “effectively connected” to a USToBGains from real property considered
“effected connected” to a USToBTax treaties often reduce or eliminate
U.S. for many types of income
©2008 Prentice Hall, Inc. 16-21
Taxation of U.S. Taxation of U.S. Businesses Operating Businesses Operating
AbroadAbroad
Domestic corps & Foreign branchesForeign corporationsDeemed paid foreign tax creditControlled foreign corporationsInversions§482 rules and tax avoidanceForeign Sales Corporations & Extra-
territorial Income Exclusion
©2008 Prentice Hall, Inc. 16-22
Domestic Corporations
Domestic subsidiary corporationsCan file consolidated return w/parentParent protected from foreign creditors
of subsidiaryForeign branches
Income and losses taxed currentlyEligible for direct FTC (described earlier)
©2008 Prentice Hall, Inc. 16-23
Foreign Corporations
If domestic corp owns 10% of foreign corp, domestic corp eligible for “deemed paid credit” for dividends received from foreign corp
10% domestic corp owner cannot claim DRD on non-USToB earnings
U.S. tax on foreign sub’s income deferred until dividends received
©2008 Prentice Hall, Inc. 16-24
Deemed Paid Foreign Tax Credit
Separate basket if own ≥ 10% & ≤ 50%Called Sec. 902 or 10/50 dividends
Div paid to domestic corp
(from post 1986 undist
earningsAll post 1986 undistributed
earnings
X
Creditable taxes paid or accrued by foreign
corp (post 1986)
=Deemed
paid foreign
tax credit
©2008 Prentice Hall, Inc. 16-25
Controlled ForeignCorporations (CFC) (1 of 3)
Typical tax-avoidance scenario of a CFC
U.S.
ManufacturingCorporation(Chicago)
Foreign SalesSubsidiary
(Island Corporation)
ForeignPurchasers
of U.S.Manufacturer’s
Products
Billing of tax haven sales subsidiary by U.S. manufacturer
Billing of foreign purchasers by tax haven
sales subsidiary
Physical flow of goods
©2008 Prentice Hall, Inc. 16-26
Controlled ForeignCorporations (CFC) (2 of 3)
CFC definition> 50% of foreign corp stock owned by
U.S. shareholdersU.S. shareholder defined if owns 10% of
stock
Some income forms (Subpart F income) of the CFC are taxed in the year in which they are earnedSee Figure C16-2
©2008 Prentice Hall, Inc. 16-27
Controlled ForeignCorporations (CFC) (3 of 3)
Tax-deferred earnings can be taxed under Subpart F when invested in U.S. property
Previously taxed income distributed tax-free
Special rules apply to the sale or exchange of CFC stock
©2008 Prentice Hall, Inc. 16-28
§482 Rules & Tax Avoidance(1 of 3)
Tax avoidance opportunity high for domestic parent and 100% owned subsidiary (see slide 16-25)U.S. parent sells goods/services at
less than FMV to 100% foreign sub, OR
Foreign sub pays less than FMV for use of U.S. parent’s intangibles (e.g., patents)
©2008 Prentice Hall, Inc. 16-29
§482 Rules & Tax Avoidance(2 of 3)
§482 authorizes IRS to distribute, apportion, or allocate gross income, deductions, credits or allowances between or among controlled entities
©2008 Prentice Hall, Inc. 16-30
§482 Rules & Tax Avoidance(3 of 3)
§482 Regs hold that transactions between entities must meet arm’s-length standardConsistent w/ transactions
between uncontrolled entitiesComparable transaction under
comparable circumstances
©2008 Prentice Hall, Inc. 16-31
Inversions (1 of 3)
U.S. corps subject to U.S. tax on world- wide (WW) income, while foreign corps only taxed on U.S. source income
This encourages U.S. corps with substantial foreign-source income to reorganize in a foreign country through an inversion
©2008 Prentice Hall, Inc. 16-32
Inversions (2 of 3)
Basics of inversions1.U.S. corp merges into a foreign entity or
transfers its assets to a foreign entity2.Owners of U.S. corp exchange U.S. corp’s
stock for equity in foreign entity3.Same owners continue to conduct both
U.S. and foreign business through the new foreign entity, but only U.S. source business subject to U.S. taxation
©2008 Prentice Hall, Inc. 16-33
Inversions (3 of 3)
§§367 & 7874 added to prevent erosion of U.S. tax base
Under §367 a foreign corp (FC) will be deemed to be a U.S. corp if
FC acquired all assets of U.S. corp Former U.S. corp s/hs own ≥80% of
FC & FC does not conduct much business
in foreign country of incorporation
Comments or questions about PowerPoint Slides?Contact Dr. Richard Newmark atUniversity of Northern Colorado’s
Kenneth W. Monfort College of [email protected]
16-34©2008 Prentice Hall, Inc.