Fundamentals of International Taxation

Taft Law School

The Bernard E. Witkin School of Law

Fundamentals of International Taxation

(TAX 709)

Taft Law School Fundamentals of International Taxation

(TAX 709)

Copyright 2003, 2004, 2005, 2006, 2007, 2009, 2010, 2011, 2012 The Taft University System, Inc.

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Introduction

You should take the time to carefully read this syllabus and the Student Handbook before you begin the Lesson Assignments.

This syllabus contains the assignments and related materials for the above referenced course.

This course provides the student with a practical command of the tax issues raised by international transactions and how these issues are resolved by U.S. tax laws. The text is divided into four major components. Part 1 provides an overview of the U.S. tax system for taxing international transactions and also discusses U.S. jurisdictional rules and source of income rules. Part 2 explains how the U.S. taxes the foreign activities of U.S. persons, and includes the foreign tax credit, anti-deferral provisions, foreign currency translation and transactions, export tax benefits, planning for foreign operations, and state taxation of foreign operations. In Part 3, the authors describe how the U.S. taxes the U.S. activities of foreign persons, including the taxation of U.S. source investment income and U.S. trades or businesses. In addition, planning for foreign owned U.S. operations is discussed. The final Part discusses common issues encountered with both outbound and inbound activities, including intercompany transfer pricing, tax treaties, cross border mergers and acquisitions, and international tax practice and procedure.

In addition to meeting the accreditation standards of the Distance Education and Training Council, this course has been designed to comply with the Statement on Standards for Continuing Professional Education (CPE) Programs issued jointly by the American Institute of Certified Public Accountants and the National Association of State Boards of Accountancy. Consistent with the AICPA Statement on Standards for Continuing Professional Education Programs, the University recommends fifteen credits (hours) be awarded for each semester unit completed. CPE credits are earned at the time a course is completed. With respect to continuing education for enrolled agents, courses within the Program also meet the standards of Treasury Department Circular 230. A copy of the final grade report is generally acceptable evidence of completion. If requested by an accountancy board or the Internal Revenue Service, an official transcript will be provided at no cost.

The State Bar of California has approved the University as a provider of continuing legal education under Section 9 of the Minimum Continuing Legal Education Rules and Regulations. California attorneys should refer to information available from the State Bar of California for requirements and limitations under the law.

Taxation in general, and corporate tax in particular, can come as a shock to students because the subject matter is more difficult and the coverage more intensive than in many graduate business or law school courses. This is one of the major reasons occupational experience is required for admission to the LLM Program.

In order for students to achieve the expected student learning outcomes, they must have a fundamental understanding of balance sheets and income statements.

This course provides the student with a practical command of the tax issues raised by international transactions and how these issues are resolved by U.S. tax laws. The text is divided into four major components. Part 1 provides an overview of the U.S. tax system for taxing international transactions and also discusses U.S. jurisdictional rules and source of income rules. Part 2 explains how the U.S. taxes the foreign activities of U.S. persons, and includes the foreign tax credit, anti-


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deferral provisions, foreign currency translation and transactions, export tax benefits, planning for foreign operations, and state taxation of foreign operations. In Part 3, the authors describe how the U.S. taxes the U.S. activities of foreign persons, including the taxation of U.S. source investment income and U.S. trades or businesses. In addition, planning for foreign owned U.S. operations is discussed. The final Part discusses common issues encountered with both outbound and inbound activities, including intercompany transfer pricing, tax treaties, cross border mergers and acquisitions, and international tax practice and procedure.

Expected Student Learning Outcomes

After successful completion of this course students will be able to explain and/or determine the following:

The taxing of the foreign income of its citizens.

The taxing of the U.S. income of non-citizens.

The fiscal residence of companies.

Rules for determining income and expenses.

Obstacles to flow of funds between parent and subsidiary entities.

Tax incentives in developing countries.

Public international law and taxation.

The comparison of the United States income tax system to that imposed by other countries around the world.

Required Materials

A Practical Guide to U.S. Taxation of International Transactions (Eighth Edition, 2011), by Michael S. Schadewald and Robert J. Misey, Jr. ISBN 97800808026822 International Income Taxation Code and Regulations 2012 - 2013 Edition ISBN 9780808029793

Students must also have access to the Internal Revenue Code and related Regulations. (The complete Code and Regulations are available through Lexis. For students preferring a printed copy, Warren, Gorham & Lamont offers a paperback version.)

Optional Readings:

Journals such as the Journal of International Taxation provide current topical and supplemental coverage for those areas of student interest beyond required coursework

Academic Engagement

Each academic course at Taft Law School is assigned a semester unit value equivalent to the commonly accepted and traditionally defined units of academic measurement in accredited institutions. Credit bearing courses are measured by the learning outcomes normally achieved


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through 45 hours of student work for one semester unit. For example, a course with a value of 3 semester units would require a typical student to commit 135 hours to complete the course requirements.

Lesson Assignments

This course contains a number of lesson assignments. Work through the lessons one at a time. Unless otherwise instructed, you should complete all assignments for a particular lesson in one WORD document.

When you complete all of the assignments in a lesson, submit it to the faculty for grading and feedback. Submit only one lesson at a time, completing them in sequence. Continue on to the next lesson, but be sure to incorporate any feedback received on previous lessons into your subsequent assignments – if necessary. Completed and submitted Lesson Assignments will be graded with feedback within 10 days.

Final examination procedures are set forth in the Student Handbook.

Format

It is important you carefully review what form of writing is required of each writing assignment. Assignments in the Program may include writing a memorandum to the client’s file, a letter to a client, a “brief” of a case or correspondence to the Internal Revenue Service. Your grade will be negatively affected if you don’t follow the specific instructions (i.e., if you are requested to write a letter to a client but you instead write a memo to the file.)

Memorandums to the file should follow the format used in the Tax Research Techniques course and include appropriate citations. Client letters should be formatted consistent with normal business communications. Letters should be written in such a manner a reasonable business person (i.e., a non-accountant or non-attorney) could understand the communication.

Case briefs should be in a style similar to the technique set forth in the text Legal Research, Writing & Analysis.

Memorandums to the file and communications with the Internal Revenue Service should generally contain a greater number and more specific citations than letters to clients.

Your lesson assignment responses should be evidenced from the course textbook and/or from peer-reviewed sources not more than 5 years old. In general, Wikipedia is not a professionally-reviewed resource and should not be used as an assignment reference.

You must cite your references so that readers can verify your conclusions, and easily determine what is your work, and what is paraphrased or taken directly from other sources. 7 Failure to give credit for the work of others in your assignments and writing projects constitutes plagiarism.

Citation Machine: http://citationmachine.net/index2.php?start=&reqstyleid=2&newstyle=2&stylebox=2 Citation Machine is an online tool to assist in proper citation of researched information.


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Academic Integrity It is the policy of the University that any student found guilty of cheating and/or plagiarism will be subject to immediate dismissal from the University. All students are required to sign a Coursework Certification Form for each course. This form is provided as a link in the last lesson of each course.

Evaluation

Faculty Advisors will refer to the following grading rubric when evaluating your assignments:

Excellent Above Average Satisfactory Needs

Improvement Unsatisfactory

Understanding of Material and Lesson Objectives

Demonstrates a thorough

understanding of the material.

Demonstrates an adequate

understanding of material

Responses are generally accurate, but at times

lacking coherence.

Demonstrates a marginal

understanding of the material and lesson

objectives.

Provides marginally complete and/or

inaccurate responses showing little

understanding of the material

Articulation, Synthesis and

Analysis of Concepts

Work is articulated consistent with the

degree level integrating or

synthesizing concepts in an original and innovative way.

Work demonstrates a solid knowledge of

concepts and theories with some individual analysis of issues.

Work demonstrates an elementary knowledge of

concepts but lacks original thought and

analysis.

Work is primarily paraphrased or quoted directly from the text

or other sources.

Responses demonstrate little or no

individual analysis.

No individual analysis of concepts.

Work is poorly

articulated and/or derived entirely from the

textbook.

Composition, Presentation,

and References

Work presented in a logical and coherent way supported by sound resources.

Citations are

composed in proper format with few or no

errors.

Work presented is grammatically sound.

Resources are

appropriate and cited in proper format with few

errors.

Work is grammatically sound with a few minor

errors.

Resources may be of questionable authority, but are cited in proper format with few errors.

Work contains frequent grammatical errors.

Resources are few,

non-existent, or may be of questionable

authority.

Frequent errors in composition, grammar

and presentation.

Quoted material is incorporated without the use of quotation marks or citation (plagiarism).

If at any time you desire additional feedback, you should contact your faculty advisor directly via email. Feel free to ask questions about course progress, grades, etc., at any time, and remember that the faculty and administration are interested in helping you learn and succeed. Your grade will be influenced by the accuracy of your research and the quality of your writing. The extent of research necessary will vary from assignment to assignment. In most cases, your work product should not simply consist of quoting from the assigned text.

In addition to the rubric above, when grading your assignments the faculty will consider three general components:

1. A demonstrated understanding of the material and the learning objectives.

2. Your ability to articulate, synthesize and analyze the concepts and issues presented in the material.


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3. Clear and logical composition supported by examples and appropriate references.

The Lesson Assignments are weighted equally. Total Possible Points = 800 (100 Points per Lesson)

It is important you carefully review what form of writing is required of each writing assignment. Assignments in the Program may include writing a memorandum to the client’s file, a letter to a client, a “brief” of a case or correspondence to the Internal Revenue Service. Your grade will be negatively affected if you don’t follow the specific instructions (i.e., if you are requested to write a letter to a client but you instead write a memo to the file.)

Letter Grade GPA Percentage

A 4.00 90-100 (Outstanding) A- 3.67 88-89 B+ 3.33 84-87 B 3.00 80-83 (Satisfactory) B- 2.67 78-79 C+ 2.33 74-77 C 2.00 70-73 (Passing but below the standard accepted in graduate study) C- 1.67 68-69 D+ 1.33 64-67 D 1.00 60-63 (Does not meet standard for graduate study, coursework must be repeated for credit) D- 0.67 59 F <0.67 58 or below (Failure)


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Lesson 1 – Overview of U.S. Taxation of International Transactions

Introduction U.S. taxation of international transactions is a developing area. We encourage students to keep a close watch on new law developments. In addition to resources provided through Lexis, the textbook publisher’s tax home page at http://tax.cchgroup.com posts tax briefings that are freely available to the public on substantial new tax law developments. This lesson begins with an overview of topics covered in the text and proceeds with a conceptual overview to international tax jurisdiction; i.e., when can a country impose its tax? There are two types of taxing jurisdiction: (i) residence based taxation, where a country taxes individuals who are citizens or residents of the country and (ii) source based taxation, where a country taxes income that is derived from or “sourced” in that country. Due to overlapping taxing authorities (i.e., the same income may be subject to tax by more than one country, especially when income is earned in one country by a resident of a different country), a country will either (i) exclude income sourced outside its boundaries or (ii) give the taxpayer a credit for tax paid to a foreign jurisdiction. To the extent that a particular country wishes to address the issue of double tax due to overlapping jurisdiction, the country may enter into a tax treaty that avoids or limits double taxation. The U.S. adopts a hybrid of residence-based taxation and source based taxation, with a credit to avoid double tax. Under its residence-based system, U.S. citizens, resident aliens (i.e., green card holders), domestic corporations, domestic partnerships and domestic estates and trusts are subject to U.S. tax. The U.S. then gives a credit to U.S. taxpayers for the income tax they pay to a foreign jurisdiction. However, under the credit system, the U.S. limits the amount of credit against U.S. tax to the amount of tax the U.S. would impose on the foreign income. The U.S. also allows U.S. citizens who work abroad to exclude their foreign-earned income from U.S. taxation. A person who has the legal right to reside in the U.S. (a “resident alien”) is taxed by the U.S. in the same manner as a U.S. citizen. Aliens are classified as residents if either of two tests is met: (i) the green card test, where an alien has the status of a lawful permanent residence, and (ii) the substantial presence test. Under the substantial presence test, an alien who is present in the United States for 183 days in the year is deemed a U.S. resident. When determining whether an alien has been present in the United States for 183 days, a three-year look back rule applies; days in the current year count as a full day, days in the past year count as one-third of a day, and days in the second past year are counted as one-sixth of a day. While under normal circumstances, a U.S. citizen is taxed by the U.S. on worldwide income, regardless of where it is earned, under the foreign earned income exclusion, the U.S. will allow a U.S. citizen or resident who works abroad to exclude up to $91,400 (in 2009) of income and taxable fringe benefits from U.S. tax. In order to qualify for the exclusion, the U.S. citizen must be present in the foreign country for 330 days during a 12-month period and have a tax home in the foreign country. The exception also allows the U.S. citizen to exclude a housing cost amount. U.S. persons are subject to U.S. tax on their worldwide income, whereas foreign persons are subject to U.S. tax only on certain types of U.S. source income. This difference in treatment could lead U.S. persons to strategically forfeit their U.S. citizenship. To combat such tax-motivated expatriations, Congress created a special tax regime applicable for the 10 years following expatriation to tax all U.S. source


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income (which, for these purposes, includes gain on the sale of stock) at progressive U.S. rates if the expatriate meets certain requirements. The current U.S. jurisdictional system reflects a variety of tax policy objectives, including fairness, the need to collect tax revenues, economic neutrality, and enforcement constraints. The concept of fairness encompasses both horizontal equity and vertical equity. Horizontal equity requires similar treatment of taxpayers in similar economic situations, whereas vertical equity requires higher tax burdens for higher-income taxpayers. Suggested Internal Revenue Code Sections: 871; 881; 882; 911; 1441; 1442 and 7701.

Lesson Learning Objectives By the conclusion of this Lesson you should be able to demonstrate knowledge with respect to:

The U.S. Jurisdictional System. The definition of a Resident Alien. The exclusion for foreign-earned income. The rules regarding expatriation.

Reading Study Chapters 1 and 2 of the text.

Assignments NOTE: List the question first, and then your response.

Be sure to properly site your sources, both in-text and with a reference list at the conclusion.

If you use an online source to support your answers, you must provide a properly formatted link to the source. Make sure your sources are credible.


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Assignment Questions

1. U.S. tax law contains a two-pronged system for taxing the U.S.-source income of foreign persons. Briefly explain this system.

2. Assume you are on the staff of a U.S. Senator from your home state. The Senator is interested in reforming the U.S. tax system, and has asked you for your opinion of the current system for taxing the foreign operations of U.S. companies, as well as potential alternative systems for taxing such income. The Senator is particularly interested in the relative effects of these different systems on U.S. tax revenues and the competitiveness of U.S. companies in foreign markets. Prepare a one to two-page memorandum that you could use to brief the Senator on these issues.

3. USAco is a domestic corporation that manufactures products in the U.S. for distribution in the U.S. and abroad. During the current year, USAco derives a pre-tax profit of $10 million, which includes $1 million of foreign-source income derived from a country X sales office that is considered an unincorporated branch for U.S. tax purposes. The country X corporate income tax rate is 50% and the U.S. tax rate is 35%.

a. What would be the worldwide effective tax rate on the $1 million of foreign profits, assuming the U.S. taxes the worldwide income of domestic corporations, but allows an unlimited credit for foreign income taxes?

b. What would be the worldwide effective tax rate on the $1 million of foreign profits, assuming the U.S. allows a credit for foreign income taxes, but the credit is limited to the U.S. tax attributable to foreign-source income?

c. What would your answer to part (b) change if the foreign tax rate was 30% rather than 50%?


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Lesson 2 – Source-of-Income Rules and Foreign Tax Credit

Introduction U.S. persons are taxed on their worldwide income, whereas foreign persons are taxed only on income “sourced” in the United States. This lesson begins with an overview of the rules governing when income has its source inside versus outside the United States. If a U.S. taxpayer has paid more foreign taxes than are creditable, it is said to be in an “excess credit position;” if all the foreign taxes paid by the U.S. taxpayer are creditable, it is said to be in an “excess limitation position.” With regard to foreign persons, the source rules play a much different role; to the extent income is sourced here, the U.S. imposes an income tax. There are various rules and exceptions that apply to determine the source of income. Interest is generally sourced based on the residence of the payer. Dividend income is also sourced based on the residence of the payer, subject to a different look through rule. Income from personal services is sourced where the services are performed. Rent and royalty income is sourced based on where the underlying property is used. Income from the disposition of real property is sourced based on the location of the real property. Additionally, the sale of stock of a U.S. corporation may give rise to U.S. source income if the corporation was a U.S. real property holding company, which applies when 50% or more of a domestic corporation’s assets consist of real property interests located in the United States. Income from the sale of personal property is generally sourced according to the residence of the seller. Thus, income from the sale of stock of a foreign affiliate is generally sourced in the U.S. unless: (i) the affiliate is a foreign corporation, (ii) the sale occurs in the foreign jurisdiction, and (iii) over 50% of the foreign affiliate’s gross income over the preceding three years was derived from the active conduct of a foreign business, in which case the gain from the sale of the affiliate is foreign source. Income from the sale of inventory is sourced where the sale occurs if the inventory is not manufactured by the taxpayer (i.e., if it is bought for resale). Manufactured inventory is generally sourced under the 50-50 method, which requires that 50% of the sale be sourced using a sales activity factor and the other 50% be sourced using a production activity factor. The 50% sourced under the sales activity factor is apportioned between U.S. source and foreign source based on the ratio of foreign source export sales to all export sales. The 50% sourced under the production activity factor is apportioned based on the ratio of the adjusted basis of production assets located abroad to the adjusted basis of all production assets. Generally, deductions are sourced according to a two-step process; first, deductions are allocated to their related income producing activity. Second, deductions are apportioned between the U.S. and foreign source gross income based on one of several factors, including gross income, number of units sold, salaries paid, etc. Specialized rules apply to certain deductions, most notably, interest expense. Interest deductions generally are sourced based upon the ratio of foreign assets to worldwide assets. Suggested Internal Revenue Code Sections: 861; 862; 863; 865; 871; 881; 882 and 904. Next we will explore foreign tax credit. The U.S. taxes U.S. persons on their worldwide income, regardless of source. Since other countries frequently impose their tax on income sourced within their jurisdiction, income earned by a U.S. person can be subject to double tax. In order to mitigate the effects of this double tax on U.S. persons, the U.S. allows U.S. persons to claim a credit against U .S. taxes for foreign taxes paid.


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Computing the foreign tax credit is a three-step process:

(i) Compute the pool of creditable foreign taxes. In order to be creditable, the “tax” must be a tax on income, similar to the U.S. income tax.

(ii) Calculate the foreign tax credit limitation. The maximum amount of foreign taxes that can be credited against U.S. tax is the portion of that U.S. tax attributable to foreign source income.

(iii) The foreign tax credit equals the lesser of creditable foreign taxes (step 1) or the foreign tax credit limitation (step 2). Excess foreign tax credits can be carried back one year and forward ten years.

If the taxpayer is in an “excess credit position,” it has paid more in foreign taxes than are creditable against U.S. tax. Strategies to reduce the excess foreign taxes include (i) reducing foreign taxes by using credits, exemptions, deductions, etc. in the foreign countries, (ii) increasing the amount of income that is classified as foreign source income for U.S. tax purposes, and (iii) cross crediting, that is, the blending of low tax and high tax foreign source income within the same foreign tax credit limitation. In order to restrict the ability of U.S. taxpayers to engage in cross-crediting, separate limitations must be computed for separate categories of income. In other words, a separate foreign tax credit is determined with regard to each category of income. Cross crediting is still allowable, however, to the extent the taxpayer has income from different countries within the same category of income. For tax taxable years beginning after 2006, there are two separate income categories, passive category income and general category income. For taxable years beginning before 2007, there were eight separate income categories, including: (i) passive income, (ii) high withholding tax interest, (iii) financial services income, (iv) shipping income, (v) certain dividends from a domestic international sales corporation (DISC) or former DISC, (vi) foreign sales corporation (FSC) taxable income attributable to foreign trade income, (vii) certain distributions from a FSC or former FSC, and (viii) general limitation income (residual basket). For purposes of computing the taxpayer’s foreign tax credit limitation, special rules apply when a taxpayer has either an overall foreign loss, or a foreign loss within one of the separate basket limitation. Foreign income taxes that are not creditable due to the limitation may be carried back one year and carried forward up to ten years (but must stay within their respective baskets). U.S. persons can use foreign tax credits to offset not only their regular income tax for the year, but also their alternative minimum tax. A U.S. corporation that has an 80% or more owned domestic subsidiary is not subject to tax on the dividends from its subsidiary because of a 100% dividend received deduction. However, since a U.S. corporation with a foreign subsidiary cannot claim a dividend received deduction for a dividend received from that foreign subsidiary, income earned by the foreign subsidiary is subject to tax both by the foreign jurisdiction and by the U.S. To reduce the double tax, a U.S. corporation with a foreign subsidiary may claim a foreign tax credit for a portion of the taxes paid by the subsidiary to the foreign jurisdiction. Since the dividend received is net of the foreign taxes, the U.S. corporation must include in income not only the dividend received, but also the amount of foreign taxes the subsidiary paid with respect to those earnings (the “gross up”). In order to claim the deemed foreign tax credit, a U.S. corporation must own 10% or more of the voting stock of a foreign corporation and receive a dividend from that foreign corporation. If a U.S. corporation has a chain of foreign subsidiaries, the relevant ownership percentages are determined by multiplying the


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percentage ownership of each 10% owned subsidiary by the percentage ownership of that subsidiary’s subsidiary, and the indirect ownership must equal 5%. For example, if a U.S. corporation owns 50% of the first tier foreign subsidiary, which in turn owns 20% of the second tier foreign subsidiary, the U.S. corporation indirectly owns 10% of the second tier subsidiary, in which case a deemed paid credit is allowed with respect to the taxes paid by the second tier foreign subsidiary. As soon as the constructive ownership drops below 5%, no deemed foreign tax credit is allowable. Fourth-, fifth, and sixth-tier foreign corporations must be CFCs in order to qualify for a deemed paid credit. In order to determine the amount of foreign income taxes attributable to a dividend from a foreign corporation, all post-1986 earnings and profits of the foreign subsidiary are pooled as are all post-1986 foreign income taxes paid. Thus, foreign taxes are pulled out to the U.S. parent corporation proportionately with respect to the amount of the dividend. If the foreign corporation making the dividend distribution is a “controlled foreign corporation” (i.e., the foreign corporation is owned more than 50% by U.S. shareholders, counting only U.S. shareholders who own at least 10% of the foreign corporation’s stock), the character of the dividend income is the same as that of the foreign subsidiary’s underlying earnings. A look-through rule also applies to dividends received by a domestic corporation from a noncontrolled Code Sec. 902 corporation (or “10/50 company”). A foreign corporation is a 10/50 company if a domestic corporation owns between 10% and 50% of the foreign corporation (in which case the U.S. corporate shareholder satisfies the 10% or more ownership requirement for claiming a deemed paid credit with respect to a dividend from the foreign corporation), but the foreign corporation does not meet the more than 50% U.S. ownership requirement for CFC status. A corporation claiming a foreign tax credit must attach Form 1118, Foreign Tax Credit-Corporations, to its tax return. An individual claiming a foreign tax credit must attach Form 1116, Foreign Tax Credit, to his or her tax return. Taxpayers must complete a separate Form 1118 (or Form 1116) for each separate category of income limitation. If a U.S. corporation has a subsidiary in a high tax foreign jurisdiction, no U.S. tax will be due on a repatriated dividend since the deemed foreign tax credit associated with the dividend will exceed the U.S. tax otherwise due on that dividend. Alternatively, repatriated dividends from corporations operating in low tax foreign jurisdictions will be partially subject to U.S. income tax since the deemed paid foreign tax credit will not fully offset the U.S. tax liability on the dividend. Thus, the U.S. corporation should attempt to coordinate dividends from high and low taxed jurisdictions (as well as other sources of high and low taxed foreign-source income) so as to be in a neutral foreign tax position. Suggested Internal Revenue Code Sections: 243; 245 and 901–905.


The importance of source rules for income and deductions.

Creditable foreign income taxes.

Excess credit versus excess limitation positions.

The restrictions on cross crediting.

Excess credit carryovers.

Computing the alternative minimum tax foreign tax credit.


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Taxation of dividend repatriations.

Computing the deemed paid credit.






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1. Engco, a domestic corporation, produces industrial engines at its U.S. plant for sale in the United States and Canada. Engco also has a plant in Canada that performs the final stages of production with respect to the engines sold in Canada. All of the output of the Canadian plant is sold in Canada, whereas only one-third of the output of the U.S. plant is shipped to Canada. The Canadian operation is classified as a branch for U.S. tax purposes. During the current year, Engco’s total sales to Canadian customers were $10 million, and the related cost of goods sold is $7 million. The average value of property, plant and equipment is $30 million at the U.S. plant, and $5 million at the Canadian plant. Engco sells all goods with title passing at the Canadian plant in the case of Canadian sales and at the U.S. plant in the case of U.S. sales.

a. How much of Engco’s export gross profit of $3 million is classified as foreign source for U.S.

tax purposes?

b. Now assume that the facts are the same as in part (a), except that the Canadian factory is structured as a wholly-owned Canadian subsidiary, rather than a branch. Engo’s sales of semi-finished engines to the Canadian subsidiary (which still represent one-third of its output) were $6 million during the year and the related cost of goods sold was $4 million. The Canadian subsidiary’s total sales of finished engines to Canadian customers (which represents all of its output) was $10 million and the related cost of goods sold is $7 million. The average value of property, plant and equipment is still $30 million at the U.S. plant, and $5 million at the Canadian plant, and Engco sells all goods with title passing at its U.S. plant. How much of Engco’s export gross profit of $2 million is classified as foreign source for U.S. tax purposes?

c. How would your answer to part (b) change if Engco sold its goods with title passing at the customer’s location?

2. In Peter Stemkowski v. Comm’r, 690 F2d 40 (1982), why was the taxpayer arguing that the

salary he received for playing hockey for the New York Rangers covered not only the regular hockey season and playoffs, but also the off-season and training camp?

3. Quantco, a domestic corporation, is an engineering consulting firm that has its main offices in San Diego, California. Because Quantco does a considerable amount of business in China, it has a branch office in Beijing. During the current year, Quantco generates a total pre-tax profit of $100 million (all from active business operations), including $80 million of profits from its U.S. operations and $20 million of profits from its Chinese operations. Assume the U.S. tax rate is 35% and the Chinese rate is 40%. Compute Quantco’s creditable foreign income taxes, foreign tax credit limitation, and excess credits (if any). Now assume that Quantco has a second foreign branch office in Singapore which generated $10 million of profits (all from active business operations), on which Quantco pays Singapore taxes at a rate of 25%. Recompute Quantco’s creditable foreign income taxes, foreign tax credit limitation, and excess credits. What is the name of the phenomenon by which the Singapore profits resulted in the elimination of the excess credits on the Chinese profits?


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4. Trikeco, a domestic corporation, manufactures mountain bicycles for sale both in the United States and Europe. Trikeco operates in Europe through Trike1, a wholly owned Italian corporation that manufactures a special line of mountain bicycles for the European market. In addition, Trike1 owns 100% of Trike2, a U.K. corporation that markets Trike1’s products in the United Kingdom. At end of the current year, the undistributed earnings and foreign income taxes of Trike1 and Trike2 are as follows: Trike1 Trike2

Post-1986 undistributed earnings ............ $90 million............ $54 million Post-1986 foreign income taxes .............. $36 million............ $27 million

During the current year, Trike2 distributed a $10 million dividend to Trike1, and Trike1 distributed a $10 million dividend to Trikeco. To simplify the computations, assume that neither

dividend distributions attracted any Italian or U.K. withholding taxes, and that the dividend received by Trike1 was exempt from Italian taxation.

Compute Trikeco’s deemed paid foreign tax credit, as well as the residual U.S. tax, if any, on the dividend Trikeco received from Trike1. Assume the U.S. tax rate is 35%.


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Lesson 3 – Anti-Deferral Provisions and Foreign Currency Transactions

Introduction A U.S. person who owns stock in a foreign corporation is not subject to U.S. tax on income earned by that foreign corporation until the earnings are repatriated in the form of a dividend distribution. Accordingly, a U.S. person can potentially accumulate earnings in a foreign corporation free from U.S. income tax until the corporation repatriates the earnings. In order to prevent abuses, U.S. tax law contains a number of anti-deferral regimes. These regimes subject U.S. shareholders of foreign corporations to immediate taxation on certain types of income earned by the foreign corporations, regardless of whether the earnings are actually repatriated. Subpart F applies to a “controlled foreign corporation” (CFC). A CFC is a foreign corporation whose stock is owned more than 50% by “U.S. shareholders.” A U.S. shareholder is any U.S. person who owns 10% or more of the foreign corporation’s stock. If a foreign corporation is a CFC, all U.S. shareholders must include in income a deemed dividend equal to their pro-rata portion of the CFC’s tainted earnings, which include Subpart F income and earnings invested in U.S. property. Subpart F income primarily includes insurance income and foreign base company income, as follows. (i) Insurance income. Since premiums and other income from insurance represents the type of income that is easily shifted to a foreign corporation in order to avoid or defer U.S. taxation, income from insurance policies is included Subpart F income to the extent that the insurable interest is located outside the CFC’s country of incorporation. (ii) Foreign base company income. There are four categories of foreign base company income, as follows:

(a) foreign personal holding company income, which is passive investment income earned by a foreign corporation;

(b) foreign base company sales income, which consists of income from property purchased from or sold to a related party if the property is manufactured outside and sold for use outside the CFC’s country of incorporation;

(c) foreign base company services income, which is income derived from performing services outside the CFC’s country of incorporation for a related party; and

(d) foreign base company oil related income, which consists of certain types of income derived from selling or processing petroleum or related products.

Tainted earnings also include earnings of the CFC invested in U.S. property. Examples of U.S. property include loans to U.S. shareholders, stock of a related domestic corporation, and tangible property located in the United States, such as U.S. manufacturing facilities. When determining Subpart F income, various special rules apply, including:

(i) If a CFC’s Subpart F income is less than both $1 million and 5% of the CFC’s income for the year, none of the CFC’s income is treated as Subpart F income (de minimis rule).

(ii) If a CFC’s Subpart F income exceeds 70% of the CFC’s income for the year, all of the CFC’s income is treated as Subpart F income (de maximis rule).

(iii) A U.S. shareholder can elect to exclude from its taxable income any Subpart F income that is subject to an effective foreign tax rate that exceeds 90% of the maximum U.S. corporate tax


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rate (high tax exception). This rule reflects the reality that a CFC is paying foreign taxes at a rate that exceeds 90% of the U.S. rate; there is little or no residual U.S. tax to be collected.

A deemed dividend under Subpart F carries with it a deemed paid foreign tax credit computed in the same manner as for an actual dividend distribution. In addition, a U.S. shareholder that receives an actual dividend distribution from a CFC may exclude that dividend from U.S. taxable income to the extent the distribution is out of earnings taxed to the U.S. shareholder in a prior taxable year. The Subpart F provisions prevent U.S. shareholders of a foreign corporation from deferring U.S. income tax on the foreign corporation’s earnings only if the foreign corporation is closely held. However, U.S. shareholders of foreign mutual and investment funds fall outside those provisions due to their widespread ownership. The passive foreign investment company (“PFIC”) regime was enacted in 1986 to address this gap. A PFIC is a foreign corporation if 75% or more of its income is passive income or 50% or more of its assets are passive investment assets. If a foreign corporation is a PFIC, all U.S. shareholders (regardless of percentage ownership) are taxed on the PFIC’s undistributed earnings using one of the following three methods:

(i) Qualified electing fund. U.S. shareholders may elect to be taxed as though the PFIC were a pass-through entity, with U.S. shareholders reporting their pro rata share of the PFIC’s earnings for the current year.

(ii) Excess distributions. If the U.S. shareholder does not make a qualified electing fund election,

the U.S. shareholder will be subject to an interest charged on the amount of the U.S. income tax that is deferred by accumulating income in the PFIC rather than paying current dividends. The interest rate is based on the rate applicable to an underpayment of income tax, and is imposed on (i) a gain realized on the sale of the PFIC stock, or (ii) a distribution that is an “excess distribution.” An excess distribution is a current year distribution that exceeds 125% of the average actual distributions over the preceding three-year period. If the distribution is an excess distribution, the distribution is treated as though it were received ratably over the entire period that the shareholder held the PFIC stock, and interest is imposed on the underpayment of tax attributable to the inclusion of the deemed dividend over each of those prior years.

(iii) Mark-to-market election. A U.S. shareholder of a PFIC may make a mark-to-market election

with respect to the stock of the PFIC if such stock is marketable. Under this election, any excess of the fair market value of the PFIC stock at the close of the tax year over the shareholder’s adjusted basis in the stock is included in the shareholder’s income. The shareholder may deduct any excess of the adjusted basis of the PFIC stock over its fair market value at the close of the tax year.

Given the overlapping definitions, a foreign corporation could be classified as both a FC and a PFIC, thereby subjecting U.S. shareholders to both anti-deferral regimes. A CFC that falls within the definition of a PFIC will not be classified as a PFIC with regard to 10% U.S. shareholders. As a result, U.S. shareholders who are taxed on the foreign corporation’s Subpart F income will not be subject to a PFIC inclusion. However, U.S. shareholders who own less than 10% will still be subject to the PFIC regime.

If a U.S. shareholder sells stock of a foreign corporation that at any time during the last five years was a CFC, the gain is taxed as a dividend to the extent of the corporation’s post-1962 accumulated earnings


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and profits. Gain in excess of the post-1962 accumulated earnings and profits is taxed at capital gain rates. The American Jobs Creation Act of 2004 repealed both the foreign personal holding company regime and the foreign investment company regime, effective for tax years beginning after 2004. Suggested Internal Revenue Code Sections: 951–965; 1248; and 1291–1298 This lesson continues with an overview of the issues that arise when a U.S. person transacts business in foreign currency. A foreign branch that is a qualified business unit (QBU) will first determine its profits and losses using the local currency, and then translate that net profit or loss into U.S. dollars using the average exchange rate for the year. Foreign income taxes incurred by an accrual basis taxpayer are translated into U.S. dollars using the average exchange rate for the taxable year. Currency exchange gains and losses arise from dispositions of nonfunctional currency, as well as three types of transactions denominated in a nonfunctional currency. These transactions include (a) lending or borrowing funds pursuant to a debt instrument, (b) accruing receivables and payables when the receivable or payable will be satisfied at a future date, and (c) the disposition of a foreign currency option, forward, or futures contracts. The entire amount of gain or loss arising from the disposition of a nonfunctional currency or a transaction involving a foreign currency contract is a currency exchange gain or loss. Currency exchange gains and losses are ordinary in nature and sourced based on the residence of the taxpayer. In contrast, gains and losses from debt instruments and receivables and payables denominated in a nonfunctional currency are treated as currency exchange gains and losses only to the extent such gains and losses are attributable to a fluctuation in the currency exchange rate between the date the item was accrued (“booking date”) and the date the item was paid (“payment date”). To protect against this risk, U.S. taxpayers frequently enter into hedging transactions that “lock in” the foreign currency exchange rate. In such cases, the taxpayer may integrate the accounting for the hedge with that of the underlying business transaction. The types of transactions that are eligible for this treatment include: (i) hedged debt instruments, where a taxpayer lends or borrows funds; (ii) hedged executory contracts for the sale or purchase of goods and services; and (iii) hedged stock purchases and sales of publicly traded stock or securities. Suggested Internal Revenue Code Sections: 985–989.


Insurance income.

Foreign base company income.

Passive foreign investment companies.

Gain from the sale or exchange of a cfc’s stock.

Former foreign personal holding company and foreign investment company regimes.

Foreign currency translation and transactions.


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1. Tenco, a domestic corporation, manufactures tennis rackets for sale in the United States and abroad. Tenco owns 100% of the stock of Teny, a foreign marketing subsidiary that was organized in Year 1. During Year 1, Teny had $15 million of foreign base company sales income, paid $3 million in foreign income taxes, and distributed no dividends. During Year 2, Teny had no earnings and profits, paid no foreign income taxes, and distributed a $12 million dividend.

Assuming the U.S. corporate tax rate is 35%, what are the U.S. tax consequences of Teny’s Year 1 and Year 2 activities? 2. Beatco, an accrual basis domestic corporation, manufactures musical instruments for sale both in

the United States and abroad. Beatco’s functional currency is the U.S. dollar. Two years ago, Beatco established a branch sales office in Switzerland. The sales office qualifies as a qualified business unit with the Swiss franc (SF) as its functional currency. The branch’s tax attributes for its first two years of operations are as follows:

Year 1 Year 2 Taxable income SF40 million None Foreign income taxes (paid at end of year) SF15 million None Remittance to Beatco (paid at end of year) None SF25 million The Swiss franc had an average daily value of $0.50 during Year 1, $0.65 during Year 2, and was worth $0.60 at the end of Year 1, and $0.75 at the end of Year 2. What are the U.S. tax consequences of the branch’s activities in Year 1 and Year 2?

3. Joltco, a domestic corporation, manufactures batteries for sale in the United States and abroad. Joltco markets its batteries in Europe through its wholly owned foreign marketing subsidiary, Jolti. Jolti was organized in Year 1, and its functional currency is the pound (£). Jolti’s tax attributes for its first two years of operations are as follows: Year 1 Year 2

Taxable income £100 million None Foreign income taxes (paid at end of year) £20 million None Net Subpart F income (included in £100 million) £40 million None Actual dividend distributions (paid at end of year) None £8 million


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The pound had an average value of $1.50 during Year 1, $1.65 during Year 2, and was worth $1.60 at the end of Year 1, and $1.70 at the end of Year 2. What are the U.S. tax consequences of Jolti’s results from operations in Year 1 and Year 2? Assume that the dividend distribution in Year 2 was not subject to foreign withholding taxes.


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Lesson 4 – Export Benefits and Planning for Foreign Operations

Introduction This lesson provides an overview of the various regimes Congress has enacted over the years to provide a tax benefit for export sales by U.S. manufacturers. In 1971, Congress enacted the Domestic International Sales Corporation (DISC) regime in an attempt to stimulate U.S. exports. A DISC allowed a U.S. exporter to defer U.S. tax on a portion of its export profits by allocating those profits to a special type of domestic subsidiary known as a DISC. In 1984, Congress enacted the Foreign Sales Corporation (FSC) provisions as a replacement for the DISC. In 1999, the World Trade Organization (WTO) ruled that the FSC regime was an illegal export subsidiary and called for its elimination. In response to the WTO’s ruling, the United States enacted into law the FSC Repeal and Extraterritorial Income Exclusion Act of 2000. The WTO has ruled that the extraterritorial income exclusion (ETI) is similarly an illegal export subsidiary and called for its elimination. In the American Jobs Creation Act of 2004, Congress phased out the ETI exclusion, while phasing in the Code Sec. 199 domestic production deduction. The IC-DISC is designed as a means by which a U.S. exporter could borrow funds from the U.S. Treasury. An IC-DISC is a domestic corporation, but is not subject to the regular U.S. corporate income tax. Instead, the ICDISC’s U.S. shareholders are subject to tax on deemed dividend distributions from the IC-DISC. These deemed distributions do not include income derived from the first $10 million of the IC-DISC’s qualified export receipts each year. Therefore, an IC-DISC allows a U.S. shareholder to defer paying U.S. tax on the income derived from up to $10 million of qualified export receipts each year. The U.S. shareholder must pay an interest charge on its IC-DISC-related deferred tax liability, however. There are three requirements for an IC-DISC to receive income from a sale of export property:

(i) The property must be manufactured, produced, grown or extracted in the United States by a person other than the IC-DISC;

(ii) The export property must be held primarily for sale, lease or rental for direct use, consumption or disposition outside the United States; and

(iii) The export property must have a minimum of 50 percent U.S. content. The income of an IC-DISC from sales of export property is in an amount constituting:

4 percent of qualified export receipts, 50 percent of the combined taxable income; or The arm’s length amount determined under the transfer pricing principles of section 482.

Taxpayers rarely use the section 482 transfer pricing method to determine the arm’s length amount of income in the IC-DISC. These methods to determine the IC-DISC’s income apply regardless of whether the IC-DISC is a “commission” IC-DISC or a “buy-sell” IC-DISC. The IC-DISC may also add 10 percent of its export promotion expenses to the commission, but the export promotion expenses are typically negligible. Any of these transfer pricing methods for the IC-DISC combined with the 15 percent rate of tax on dividends by domestic corporations to U.S. individual shareholders, creates tremendous tax savings from this export benefit.


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The qualified export receipts method allocates 4 percent to the qualified export receipts from the export sales to the IC-DISC. The combined taxable income method allocates 50 percent of the taxable income from the export sales to the IC-DISC. An exporter can use any of the transfer pricing methods to achieve the greatest IC-DISC income possible. The IC-DISC rules permit the use of different methods to different sales based on product lines, recognized industry or trade usage, and even by transaction. Most of the decisions will be between the qualified export receipts and combined taxable income methods. As a simple rule of thumb, the combined taxable income method results in the largest IC-DISC income when exports have a net pretax margin of 8.7 percent or greater. On the other hand, the qualified export receipts method provides the largest IC-DISC income when the net pre-tax margin is less than 8.7 percent. If the net pre-tax margin on exports is lower than worldwide net pre-tax margins, which often occurs due to the extra shipping and administrative expenses of foreign sales, the marginal costing of combined taxable income may result in the largest commission. Finally, the exporter can maximize the IC-DISC’s income by ignoring loss sales. The IC-DISC comprehensive example illustrates the following concepts:

(i) The use of the apportionment base by which expenses are allocated to qualified export receipts for purposes of determining combined taxable income;

(ii) The choice of using the 4 percent of qualified export receipts or 50 percent of combined taxable income to determine the amount of the IC-DISC’s commission; and

(iii) The election of marginal costing for the combined taxable income method. In terms of tax relief for businesses, the most significant component of the American Jobs Creation Act of 2004 is the new Code Sec. 199 deduction equal to a percentage of the taxpayer’s qualified production activities income. When it is fully phased in for tax years beginning after 2009, the deduction will equal 9 percent of the lesser of the taxpayer’s qualified production activities income or taxable income for the year. Suggested Internal Revenue Code Sections: 114; 199; and 991–997. This lesson continues with an overview of some of the planning issues that a U.S. company must consider when doing business overseas. A U.S. company entering a foreign market for the first time may initially export its goods through independent agents. This will allow the U.S. company to sell its goods overseas without having to become familiar with a foreign jurisdiction’s tax rules and trade regulations, but at the cost of splitting its profits with the independent sales agents. As the business volume grows, it may be expeditious to invest in educating and training an in-house foreign sales department in order to avoid having to split profits with independent agents. This may be done by stationing employees in the foreign jurisdiction. If a U.S. company has employees stationed overseas, the employees may be considered a permanent establishment, thereby subjecting the profits attributable to the foreign operations to taxation by the foreign jurisdiction. Finally, to the extent business volume demands, a branch or subsidiary may be the next logical step. This, however, will definitely cause the taxpayer’s profits to be subject to foreign tax. When a U.S. company plans foreign operations, one consideration is whether the profits earned by the taxpayer are subject to the foreign taxation. This is relevant for two reasons: (i) the administrative costs associated with complying with a foreign country’s tax laws, and (ii) if the foreign jurisdiction’s tax is greater than U.S. tax, the foreign operations will result in greater overall taxes. Whether a foreign country will impose its taxing jurisdiction over profits earned by a U.S. company will depend on several factors, including the scope of the business activities conducted in the foreign jurisdiction and the foreign jurisdiction’s internal laws. Generally, a foreign country will tax all profits sourced in that jurisdiction.


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However, if the foreign country has an income tax treaty with the U.S., only those business profits attributable to a permanent establishment would be subject to foreign taxation. There are several pros and cons of each form of doing business in a foreign jurisdiction. A branch, or unincorporated arm of a domestic taxpayer, does not have the advantage of U.S. income tax deferral since profits earned by the branch are subject to immediate U.S. taxation. From the foreign jurisdiction’s standpoint, a branch will generally be considered a permanent establishment and therefore subject to foreign tax. To the extent foreign taxes are paid, the U.S. taxpayer may be able to offset U.S. income taxes with the foreign tax credit. Profits repatriated from the branch to the U.S. taxpayer are not subject to U.S. tax, and to the extent that the foreign branch experiences losses, the losses are fully deductible against the U.S. income tax. A subsidiary is a separate foreign corporation and will be subject to the foreign country’s tax. However, income earned by the subsidiary will not be taxed by the U.S. until repatriated. Thus, there exists the potential for deferral of U.S. income tax. Dividends repatriated by the foreign subsidiary to the U.S. parent corporation will be subject to U.S. tax, but that tax can be offset by the foreign tax credit. Unlike a branch, a subsidiary is a separate entity, and therefore transfers between the parent corporation and the subsidiary corporation are subject to the transfer pricing provisions of Code Sec. 482, which requires that transactions between the parent corporation and its foreign subsidiary must be conducted at arm’s length prices. The pros and cons of each form of operation are summarized in the chart below: BRANCH SUBSIDIARY

Deferral of income

A branch, as an unincorporated arm of the domestic taxpayer, will not allow the domestic taxpayer to defer income in the foreign jurisdiction. All income earned by the branch will be subject to immediate U.S. taxation. However, all losses experienced by the foreign branch will be deductible in full against U.S. income.

A subsidiary allows more control over the timing of income recognition for U.S. tax purposes, and allows the U.S. taxpayer to defer U.S. taxation until the funds are repatriated. However, these repatriated funds will be subject to U.S. tax, which may be offset, in part or in full, by the foreign tax credit.

Local tax incentives

Local tax incentives may not be available to a branch.

Local tax incentives may be available to an incorporated subsidiary.

Sale of foreign operations

A branch may only sell its assets, which may be subject to tax in the foreign jurisdiction.

If a domestic taxpayer sells stock of a foreign subsidiary, the gain may be exempt from the foreign jurisdiction’s tax.

Transfer of assets

The transfer of assets to a foreign branch is a nontaxable event.

The transfer of assets to a foreign subsidiary can be a taxable event (Code Sec. 367), in which case the U.S. taxpayer will pay tax on the difference between the assets’ adjusted bases and their fair market value.

S corporations

If the domestic taxpayer is an S corporation, the S corporation can have a branch in the foreign jurisdiction, and the S corporation shareholders will be entitled to claim the foreign tax credit for foreign taxes by the branch.

S corporation shareholders cannot claim a deemed paid foreign tax credit for foreign taxes incurred by a foreign subsidiary of an S corporation.


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Expatriated profits

Expatriated profits from a branch may not be subject to foreign taxation.

Dividends expatriated by a subsidiary generally are subject to foreign withholding taxes.

Limited liability

Operating as a branch will not insulate the domestic taxpayer from liabilities arising from business operations in the foreign jurisdiction.

A subsidiary, as a separate foreign corporation, will likely limit the U.S. taxpayer’s liability from business operations.

Ease of operations and local image

While registering a branch in a foreign jurisdiction may be easier than registering a subsidiary, a branch may not present the same local image to potential customers and employees.

While operating a subsidiary in a foreign jurisdiction may require more administrative difficulties, a subsidiary, as a separate corporate entity in the local jurisdiction, may present a better image to local

BRANCH SUBSIDIARY


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A U.S. multinational corporation will want to structure its activities to minimize the overall taxes it pays to the U.S. and foreign jurisdictions. This can be done by locating subsidiaries in low tax jurisdictions and repatriating funds only as needed, thereby gaining the benefit of deferral, sourcing more income outside the U.S. (for example, by passing title outside the U.S. and making passive investments outside the U.S.) for foreign tax credit purposes and, to the extent possible, cross crediting income earned in higher taxed jurisdictions with income earned in lower taxed jurisdictions. Additionally, the U.S. taxpayer will want to take advantage of any local tax incentives, such as tax holidays, accelerated depreciation write-offs, etc. When planning foreign operations, a U.S. taxpayer may want to consider using a hybrid entity. A hybrid entity is one that is classified differently under U.S. versus foreign law. The most common hybrid entity is one that is classified as a partnership under U.S. law and a corporation under foreign law. This can be accomplished under the “check-the-tax” regulations. While certain foreign corporations are excluded from hybrid treatment, most are eligible for this favorable treatment, with the attendant benefits of pass through U.S. taxation (including pass through of foreign tax credits), while still maintaining their status as a corporation in the host country. The globalization of U.S. business has increased the importance of understanding how a U.S. multinational corporation’s foreign operations impact the effective tax rate it reports in its financial statements. When evaluating a U.S. corporation’s effective tax rate, the de facto benchmark is the U.S. statutory rate. For large U.S. corporations, the statutory tax rate has been 35 percent since 1993. However, a U.S. company’s foreign operations can cause its effective tax rate to diverge from 35 percent. For example, operations in high-tax foreign jurisdictions can give rise to excess foreign tax credits that increase a firm’s effective tax rate. Likewise, operations in low-tax foreign jurisdictions can reduce a firm’s reported effective tax rate if management intends to permanently reinvest those earnings. Survey of Foreign Entity Classification. — This survey lists entities in selected foreign countries, discusses whether the foreign country imposes an entity level tax, describes the treatment for U.S. tax purposes if an election is not made (whether the entity is a per se corporation or has default status as a corporation or flow through entity), and considers the possibility for treatment as a hybrid or reverse hybrid entity. In each listed country, U.S. owners may operate as a sole proprietorship or a branch, which is not treated as a separate entity under the check-the box rules. Suggested Internal Revenue Code Sections: 367; 482; 904; and 7701(a).


The IC-DISC, as a means by which a U.S. exporter could borrow funds from the U.S. Treasury.

The sales of export property.

Domestic production deduction.

Determinants of host country taxation.

Structuring foreign operations.

The basics of outbound tax planning.

Financial reporting implications of international tax planning.

Foreign entity classification.


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1. Acme, Inc., a domestic corporation, manufactures goods at its U.S. factory for sale in the United States and abroad. Acme has established an IC-DISC. During the current year, Acme’s qualified export receipts are $4,000, and the related cost of goods sold is $2,400. Acme has $1,200 of selling, general and administrative (SG&A) expenses related to the qualified export receipts. Acme’s gross receipts from domestic sales are $96,000, the related cost of goods sold is $65,600, and the related SG&A expenses are $18,800. In sum, Acme’s results for the year (before considering any income allocated to its IC-DISC via a commission payment), are as follows:

Qualified export Other Total receipts sales Gross receipts $100,000 $4,000 $96,000 Cost of goods sold (direct material and labor) − 68,000 − 2,400 − 65,600 Gross profit $32,000 $1,600 $30,400 SG&A − 20,000 − 1,200 − 18,800 Net income $12,000 $400 $11,600 What is the maximum amount of income that Acme can allocate to its IC-DISC? (Assume combined taxable income equals the $400 of net income from qualified export receipts.)

2. Growco, a domestic corporation, is a tire manufacturer. Growco is planning to build a new

production facility, and has narrowed down the possible sites for this new plant to either Happystan (a low tax foreign country) or Sadstan (a high tax foreign country). Growco will structure the new facility as a wholly owned foreign subsidiary, Sproutco, and finance Sproutco solely with an equity investment. Growco projects that Sproutco’s results during its first year of operations will be as follows:

Sales ................................................................................... $400,000,000 Cost of goods sold ................................................................(290,000,000) Selling, general and administrative expenses .......................... (60,000,000) Net profit ..............................................................................$50,000,000 Assume that the U.S. corporate tax rate is 35%, the Happystan rate is 20%, and the Sadstan

rate is 40%. Further assume that both Happystan and Sadstan impose a 5% withholding rate on dividend distributions, but neither country imposes withholding taxes on interest or royalty


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payments. Compute the total tax rate (U.S. plus foreign) on Sproutco’s profits under the following assumptions:

a. The new production facility is located in Happystan and Sproutco repatriates none of its

profits during the first year. b. The new production facility is located in Happystan and Sproutco repatriates 30% of its

profits during the first year through a dividend distribution. c. The new production facility is located in Sadstan and Sproutco repatriates none of its profits

during the first year. d. The new production facility is located in Sadstan and Sproutco repatriates 30% of its profits

during the first year through a dividend distribution. e. The new production facility is located in Sadstan and Growco modifies its plans for Sproutco

as follows:

(i) finance Sproutco with both debt and equity, such that Sproutco will pay Growco $15 million of interest each year,

(ii) charge Sproutco an annual royalty of $10 million for the use of Sproutco’s patents and trade secrets, and

(iii) eliminate Sproutco’s dividend distribution. What do the results of these various scenarios suggest regarding the differential tax costs of operating in low versus high tax countries?

3. Six years ago, NewCo, Inc., a domestic manufacturer of mold-injection systems, established a

sales and service operation in Madrid, Spain. The Madrid office was structured as a Spanish corporation, but NewCo made a check-the-box election to treat the operation as a branch in order to obtain a U.S. tax deduction for the branch’s start-up losses. The Spanish operation has become quite profitable and NewCo wishes to change its U.S. tax classification from a branch to a subsidiary by filing a new check-the-box election (this is feasible since five years had passed since the first election). At the time of the conversion, the Spanish operation’s assets includes some local currency, accounts receivable from Spanish customers, an inventory of spare parts, and an extensive database of information regarding Spanish customers that the marketing personnel had painstakingly developed over the years. NewCo’s CFO has asked you to brief her regarding the U.S. tax consequences of the incorporation transaction. Briefly outline your response.


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Lesson 5 – Foreign Persons Investing and Doing Business in the United States

Introduction This lesson explores how the United States taxes foreign corporations and nonresident aliens who derive U.S. source investment-type income. The U.S. has a two-prong system for taxing the U.S. source income of foreign persons:

(i) Income derived from the conduct of a U.S. trade or business is taxed on a net basis at the regular graduated rates.

(ii) U.S. source investment-type income is taxed on a gross basis at a 30% rate. This 30% tax rate is subject to various exceptions that reduce or eliminate the U.S. tax, such as treaty exemptions, capital gains relief and the portfolio interest exemption.

U.S. payers of U.S. source investment-type income to foreign persons are required to withhold U.S. income tax at the rate of 30%. The amount of withholding is determined with regard to the gross income. No deductions are allowed against U.S. source income. There are exemptions for income effectively connected with a U.S. trade or business, income from the sale or exchange of personal property, and portfolio interest income. Finally, tax treaties often reduce the applicable withholding tax rate to 15% or less. Treaty reductions in withholding tax rates are available only to non-U.S. beneficial owners that reside in a treaty country. A non-U.S. beneficial owner that does not reside in a treaty country should incur withholding at a rate of 30%. The regulations under Sec. 1441 discuss the documentation that the payee must provide to the payer to obtain the benefit of a reduced withholding tax rate. Under the Foreign Investment in Real Property Tax Act of 1980 (“FIRPTA”), any gain realized by a foreign person on the sale of a U.S. real property interest is taxed in the same manner as income effectively connected with a U.S. trade or business. A U.S. real property interest is any ownership interest in real property located in the U.S., including stock in a U.S. real property holding company. A U.S. real property holding company is any domestic corporation if 50% or more of the corporation’s assets are U.S. real property interests. Publicly traded stock is exempt from U.S. real property holding company status. Under FIRPTA, a U.S. person purchasing property from a foreign person must withhold 10% of the gross amount realized and remit it to the U.S. Treasury as an advance payment of tax on the foreign person. Suggested Internal Revenue Code Sections: 871; 881; 897; 1441–1446. This lesson continues with a discussion of how the United States taxes nonresident aliens and foreign corporations who are engaged in a U.S. trade or business. A foreign person who wishes to operate a business in the U.S. may do so in any of several methods. Initially, the foreign person may employ independent sales agents located in the U.S. This will generally not subject the foreign person to U.S. tax, provided that the foreign person does not have a permanent establishment in the U.S. Alternatively, the foreign person may establish a branch or subsidiary in the U.S. and begin to actively conduct a trade or business located in the U.S. Once the foreign person is actively conducting a trade or business in the U.S., the profits associated with that trade or business will be taxed at the normal graduated income tax rates applicable to U.S. taxpayers. While the threshold of when a foreign person is actively conducting a trade or business in the U.S. is not clearly established, a


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foreign person will be engaged in the active conduct of a trade or business in the U.S. if the business activities are “considerable, continuous and regular.” If a foreign person does conduct an active trade or business in the U.S., all income effectively connected with that trade or business will be subject to U.S. tax. Income effectively connected with a U.S. trade or business includes certain U.S. source income, foreign source income attributed to the U.S. office, deferred income that would be attributed to the U.S. trade or business if realized immediately, and income from real property if the foreign investor elects to have it treated as such. U.S. lawmakers enacted the branch profits tax in 1986 in order to equalize the tax treatment of a U.S. branch of a foreign corporation with the U.S. subsidiary of a foreign corporation. The branch profits tax equals 30% of the branch’s annual “dividend equivalent amount.” The dividend equivalent amount equals the branch’s earnings and profits effectively connected with a U.S. trade or business, reduced by any increase in U.S. net equity. Profits earned by a domestic subsidiary of a foreign corporation are subject to two levels of tax: the subsidiary’s profits are taxed at the regular corporate rates, and any dividend distributions are subject to U.S. withholding tax. Alternatively, payments structured as interest on loans would normally give rise to a deduction at the subsidiary level and may be eligible for lower withholding tax rates under applicable treaties. Accordingly, it may be beneficial to expatriate funds as deductible interest payments. In order to strip earnings from a domestic subsidiary in this manner, the debt in question must be a valid loan under applicable U.S. principles, and not represent equity. In addition, under Code Sec. 163(j), a U.S. subsidiary that has a debt-to-equity ratio in excess of 1.5 to 1 will be denied a deduction for “disqualified interest” to the extent of its “excess interest expense.” A foreign corporation conducting business in the U.S. must file Form 1120-F, U.S. Income Tax Return of a Foreign Corporation, while nonresident aliens conducting business in the U.S. must complete Form 1040-NR, U.S. Nonresident Income Tax Return. Suggested Internal Revenue Code Sections: 163(j); 864; 871; 882; and 884.


The U.S. system for taxing foreign persons.

Withholding on U.S. source investment-type income.

Withholding procedures.

The Taxation of U.S. real property interests.

Taxation of a U.S. trade or business.

Branch profits tax.

Anti-earnings stripping provisions.

The returns and payment of tax.



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1. Hans, a citizen and resident of Argentina, is a retired bank executive. Hans does not hold a green card. At the start of Year 1, Hans paid $2.5 million for a 20-unit apartment complex located in the suburbs of Washington, D.C. Hans does not actively manage the building, but rather leases it to an unrelated property management company that subleases the building to the tenants. During Year 1, Hans had rental income of $300,000 and operating expenses (depreciation, interest, insurance, etc.) of $220,000. On the advice of his accountant, Hans made a Code Sec. 871(d) election in Year 1. At the start of Year 2, Hans sold the building for $350,000. Hans’ adjusted basis in the building at that time was $290,000. What are the U.S. tax consequences of Hans’ U.S. activities?

2. Cholati is a foreign corporation that produces fine chocolates for sale worldwide. Cholati markets

it chocolates in the United States through a branch sales office located in New York City. During the current year, Cholati’s effectively connected earnings and profits are $3 million, and its U.S. net equity is $6 million at the beginning of the year, and $4 million at the end of the year. In addition, a review of Cholati’s interest expense account indicates that it paid $440,000 of portfolio interest to an unrelated foreign corporation, $200,000 of interest to a foreign corporation which owns 15% of the combined voting power of Cholati’s stock, and $160,000 of interest to a domestic corporation.

Compute Cholati’s branch profits tax, and determine its branch interest withholding tax obligations. Assume that Cholati does not reside in a treaty country. 3. Wheelco, a foreign corporation, manufactures motorcycles for sale worldwide. Wheelco markets

its motorcycles in the United States through Wheely, a wholly-owned U.S. marketing subsidiary that derives all of its income from U.S. business operations. Wheelco also has a creditor interest in Wheely, such that Wheely’s debt to equity ratio is 3 to 1, and Wheely makes annual interest payments of $60 million to Wheelco. The results from Wheely’s first year of operations are as follows:

Sales ................................................. ............180 million Interest income ................................................ $6 million Interest expense (paid to Wheelco) ................. ($60 million) Depreciation expense ..................................... ($30 million) Other operating expenses ............................... ($81 million) Pre-tax income ................................................ $15 million Assume the U.S. corporate tax rate is 35%, and that the applicable tax treaty exempts Wheelco’s interest income from U.S. withholding tax. Compute Wheely’s interest expense deduction.


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Lesson 6 – Planning for Foreign-Owned U.S. Operations, and Transfer Pricing

Introduction This lesson provides an overview of some of the planning issues that a foreign company must consider when doing business in the United States. A central tax issue for a foreign company is whether its import profits will be subjected to U.S. taxation. As a general rule, the U.S. asserts jurisdiction over all trade or business income derived from sources within its borders. However, most tax treaties contain a permanent establishment article under which a foreign company’s business profits are exempt from U.S. taxation unless those profits are attributable to a permanent establishment located within the United States. A foreign company that is establishing a sales, distribution, service, or manufacturing facility in the U.S. can also structure the U.S. operation as either a branch or a subsidiary. Even if a foreign company forms a limited liability company in the United States, the foreign company will have to choose whether it will treat the limited liability company as a subsidiary or branch for tax purposes under the entity classification regulations. The option of forming a domestic hybrid entity or a reverse domestic hybrid entity is also available. Inbound tax planning involves the interplay of the tax laws of two or more countries. From a foreign corporation’s perspective, the objective of inbound tax planning is to reduce the U.S. and foreign taxes on U.S.-source income. U.S. taxes increase a foreign corporation’s total tax costs only to the extent they are not creditable for foreign tax purposes. The primary concern of foreign corporations operating in the United States is repatriation—sending money back to the foreign corporation at the lowest possible tax cost. Survey of U.S. Entity Classification. — This survey lists common entities in the United States, describes the treatment for U.S. tax purposes if an election is not made (whether the entity is a per se corporation or its default status is a corporation or pass through entity) and considers the possibility for treatment as a domestic hybrid or domestic reverse hybrid entity. This lesson continues with an evaluation of transfer pricing. If there were no restrictions on intercompany transfer prices, U.S. companies with affiliates in low tax foreign jurisdictions could structure their activities such that much of their profits are recognized in the low tax foreign jurisdiction. This concern has led U.S. lawmakers to impose restrictions that require U.S. affiliates to report their fair share of the worldwide profits of the multinational corporate group. This chapter gives an overview of these restrictions. The operating units of a multinational corporation usually engage in a variety of intercompany transactions. A “transfer price” must be computed for these controlled transactions in order to satisfy various financial reporting, tax, and other regulatory requirements. Although transfer prices do not affect the combined income of a controlled group of corporations, they do affect how that income is allocated among the group members. The transfer pricing provisions are contained in Code Sec. 482, and are designed to ensure that intercompany transactions are accounted for using “arm’s length” prices, that is, the prices that would be charged to unrelated corporations.


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With regard to payments for tangible property, the Regulations specify five methods for determining an arm’s length price: the comparable uncontrolled price method, the resale price method, the cost plus method, the comparable profits method and the profit split method. The taxpayer must choose the method that most accurately reflects the correct arm’s length price. There are three transfer pricing methods for intangible property: the comparable uncontrolled transaction method, the comparable profits method, and the profit split method. Again, the taxpayer must choose the method that most accurately reflects an arm’s length price. Transfers of intangibles are also subject to the requirement that the income recognized by the transferor is commensurate with the income actually earned from the use of that intangible in future years. In order to monitor transfers between related parties to ensure that the transfer pricing provisions are being followed, a domestic corporation that has a 25% or greater foreign shareholder must file Form 5472, Information Return of a 25% Foreign Owned U.S. Corporation or a Foreign Corporation Engaged in a U.S. Trade or Business. This form requires information about transactions with related foreign corporations. Additionally, U.S. shareholders of a controlled foreign corporation must file Form 5471, Information Return of U.S. Persons with Respect to Certain Foreign Corporations. If a taxpayer fails to comply with the transfer pricing provisions, it is potentially subject to two special penalties. The transactional penalty applies if the transfer price used by the taxpayer is 200% greater or 50% less than the correct transfer price. The net adjustment penalty applies if the net increase in taxable income due to a transfer pricing adjustment exceeds the lesser of $5 million or 10% of gross receipts. Both penalties are imposed at the rate of 20% (40% at higher thresholds) and are applied to the tax underpayment. The need for a “penalty-proof” transfer price is driven in part by the risk of IRS scrutiny, which depends on the volume of international transactions. If the U.S. taxpayer believes itself at significant risk due to a large volume of related party international transactions, the taxpayer may obtain an advanced pricing agreement with the IRS. This is an agreement entered into with the IRS whereby the U.S. taxpayer requests that the IRS examine and approve the taxpayer’s transfer price before it is used. Suggested Internal Revenue Code Sections: 482 and 6662(e)


The U.S. system for taxing foreign persons.






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1. A foreign corporation can structure its U.S. operations as either a branch or a subsidiary. What are the tax advantages of operating in the United States through a separately incorporated subsidiary? What are the tax advantages of operating in the United States through an unincorporated branch? What general business factors should be considered when choosing between the branch and subsidiary forms of doing business in the United States?

2. In each of the following independent situations involving transfers of tangible property, determine which transfer pricing methods applies and compute a transfer price using the appropriate method. Show all of your computations. a. Dougco, a domestic corporation, owns 100% of Thaico, a Thailand corporation. Dougco

manufactures top-of-the-line office chairs at a cost of $300 per unit and sells them to Thaico, which resells the goods (without any further processing) to unrelated foreign customers for $450 each. Independent foreign distributors typically earn commissions of 20% (expressed as a percentage of the sales price) on the purchase and resale of products comparable to those produced by Dougco.

b. Clairco, a domestic corporation, owns 100% of Shuco, a foreign corporation that manufactures women’s running shoes at a cost of $30 each and sells them to Clairco. Clairco attaches its trade name to the shoes (which has a significant effect on their resale price), and resells them to unrelated customers in the United States for $80 each. Independent foreign manufacturers producing similar running shoes typically earn a gross profit mark-up (expressed as a percentage of the manufacturing costs) of 15%.

c. Tomco, a domestic corporation, owns 100% of Swissco, a Swiss corporation. Tomco manufactures riding lawn mowers at a cost of $2,500 per unit, and sells them to unrelated foreign distributors at a price of $3,750 per unit. Tomco also sells the equipment to Swissco, which then resells the goods to unrelated foreign customers for $4,250 each. The conditions of Tomco’s sales to Swissco are essentially equivalent to those of the sales made to unrelated foreign distributors.

3. Mikco, a foreign corporation, owns 100% of Flagco, a domestic corporation. Mikco manufactures

a wide variety of flags for worldwide distribution. Flagco imports Mikco’s finished goods for resale in the United States. Flagco’s average financial results for the last three years are as follows: Sales ............................................................................ $20 million Cost of goods sold .........................................................($15 million) Operating expenses ....................................................... ($4 million) Operating profit ..............................................................$1 million Flagco’s CFO has decided to use the comparable profits method to assess Flagco’s exposure to an IRS transfer pricing adjustment by testing the reasonableness of Flagco’s reported operating profit of $1 million. An analysis of five comparable uncontrolled U.S. distributors indicates that the ratio of operating profits to sales is the most appropriate profitability measure. After adjustments have been made to account for material differences between Flagco and the uncontrolled distributors, the average ratio of operating profit to sales for each uncontrolled distributor is as follows: 6%, 8%, 10%, 10%, and 14%. Using this information regarding comparable uncontrolled U.S. distributors, apply the comparable profits method to assess the reasonableness of Flagco’s reported profits. In addition, if an adjustment to Flagco’s reported profits is required, compute the amount of that adjustment.


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Lesson 7 – Tax Treaties and Transfers

Introduction In order to encourage international trade and reduce double taxation, the U.S. frequently enters into tax treaties with other countries. These treaties generally reduce the host country’s taxation on income arising in the host country, as well as provide agreements between the countries for the disclosure of information on nonresidents doing business in that country, clarify issues regarding when income is sourced in a country, and establish procedures that should be used when a country acts inconsistently with a tax treaty. Consistent with the intention to stimulate international investment, a major purpose of a tax treaty is to reduce or eliminate double taxation by tax reductions or exemptions on certain types of income derived by residents of one country from sources within another country. The U.S. has tax treaties with over 60 countries. Although each tax treaty is unique, the United States Model Income Tax Convention of November 15, 2006 (“U.S. Model Treaty”) reflects the general pattern of most treaties. The benefits of a tax treaty are restricted to residents of the respective treaty countries. A corporation or other entity is a resident of a country if the corporation is subject to that country’s tax laws by virtue of domicile, place of management, place of incorporation or similar criteria. There are various rules that act as tie breakers in the event that a taxpayer is deemed to be a resident of both countries. Generally, these tie breakers provide that a taxpayer is a resident in the country with which the taxpayer has the most significant relationship. Since the application of a tax treaty will usually reduce a person’s tax liability, there is an incentive for taxpayers who are not residents of treaty countries to structure their business transactions to realize income in treaty countries. This can be done, for example, by forming a corporation in a treaty country, making investments out of that corporation, and attempting to claim treaty benefits. This is known as “treaty shopping.” The U.S. Model Treaty contains a limitations-on-benefits provision that is designed to restrict treaty benefits to actual residents of the treaty countries. Treaties also address the issue of whether a resident of one country is doing business in a foreign country and is subject to that foreign country’s tax and reporting requirements. If a taxpayer has a “permanent establishment” in a foreign country, the taxpayer will be subject to that country’s tax on the profits attributable to the permanent establishment. A permanent establishment includes a fixed place of business, such as an office, place of management, branch, factory, workshop, or a mine, well, quarry, or other place of natural resource extraction. However, a permanent establishment will not include a fixed place of business if the fixed place of business is used solely for activities auxiliary to the taxpayer’s business, such as a warehouse for purchasing, storing, displaying or delivering inventory. Certain types of income are entitled to receive special treatment under treaties. For example, dividends, interest and royalties are subject to tax at reduced rates, and gain from the sale of personal property generally is taxed only by the taxpayer’s resident country. In addition, treaties usually provide a de minimis rule for the personal services income of a dependent agent. Specifically, the income will not be subject to host country taxation if: (i) the dependent agent is not present in the foreign country for over 183 days in a year; (ii) the employer is not a resident of the host country; and (iii) the income is not borne by a permanent establishment located in the host country.


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Any taxpayer that claims the benefits of a treaty by taking a tax return position that is in conflict with the Internal Revenue Code must disclose the position. A tax return position is considered to be in conflict with the Code, and therefore treaty-based, if the U.S. tax liability under the treaty is different from the tax liability that would have to be reported in the absence of a treaty. This reporting requirement is waived in various situations. Outbound Transfers of Property to Foreign Corporations. — Code Sec. 367 curtails tax-free treatment for many corporate transactions if one or more of the corporations is a foreign corporation, whereas the same transaction would be accorded tax-free treatment if all the parties were U.S. corporations. If Code Sec. 367 applies, a U.S. taxpayer who transfers property outside the U.S. is treated as though the property were sold to the foreign corporation for fair market value. There are exceptions for transfers of property that would result in a loss, and certain transfers of assets for use in an active foreign business. A special branch loss recapture rule applies when a domestic corporation that has a foreign branch incorporates that branch. If a domestic corporation was operating a branch in the U.S. and incorporated that branch, the incorporation transaction would be accorded tax-free treatment. However, if a U.S. corporation has a foreign branch that has operated at a loss, the corporation will recognize gain on the branch’s incorporation. This rule is designed to prevent a U.S. corporation from deducting a foreign branch’s start-up losses against its U.S. taxable income and then converting that branch to a subsidiary when the branch becomes profitable so that the U.S. corporation can then take advantage of deferral. Acquisitive Reorganizations. — The five major type of acquisitive reorganizations are:

(i) a statutory merger (“Type A”); (ii) an exchange of the shares of the acquiring corporation for the shares of the target

corporation (“share-for-share acquisitions,” also known as “Type B”); (iii) an exchange of the shares of the acquiring corporation for the assets of the target

corporation (“shares-for-asset acquisitions,” also known as “Type C”); (iv) forward triangular mergers; and (v) reverse triangular mergers.

The policy behind taxing the U.S. shareholders that are a party to an acquisitive reorganization is to tax the appreciation in their shares before the shares leave the U.S. taxing jurisdiction. In each of the five types of acquisitive reorganizations, the outbound toll charge would apply to tax the appreciation of the U.S. shareholders in their shares of a U.S. target. A limited-interest exception applied if the U.S. shareholders obtain less than half of the transferee foreign corporation, management and 5 percent or greater shareholders do not own more than 50 percent of the foreign corporation after the transaction, the foreign corporation satisfies an active trade or business test, and the value of the foreign corporation is equal to or greater than the value of the U.S. target. Furthermore, U.S. shareholders acquiring 5 percent or more of the foreign corporation must enter a gain recognition agreement with the IRS. Over the last few years, many U.S.-based corporations have expatriated themselves to a tax-haven jurisdiction via an inversion transaction. Pursuant to these inversions, the operations of a U.S. corporation become a subsidiary of a foreign parent. In many of these inversions, the only tax cost of U.S. shareholders paying gain on the exchange of low basis shares of U.S. corporation for high-value shares of the new foreign corporation was outweighed by the tax benefit of avoiding the U.S. taxing jurisdiction over the structure’s worldwide income. If U.S. shareholders own 80 percent or more of the foreign corporation as a result of the inversion and both the U.S. corporation transfers all its operations to a foreign parent and the worldwide group does not have substantial business activities in the foreign corporation’s country of operation, the foreign


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corporation is subject to tax on its worldwide income as if it were a U.S. corporation. If the inversion transaction results in U.S. shareholders owning at least 60 percent of the foreign corporation, any applicable gain may not be offset by any net operating losses or foreign tax credits for 10 years following the inversion transaction. Just as outbound transfers to foreign corporations are taxed, inbound transfers such as subsidiary liquidations (which would otherwise be tax-free if the subsidiary and the parent were U.S. corporations) are taxable events. For example, in the case of an inbound repatriating liquidation of a foreign subsidiary, the recipient U.S. parent corporation must include in gross income a dividend equal to the subsidiary’s post-1962 undistributed earnings and profits. Provisions similar to those governing inbound repatriating liquidations of foreign subsidiaries also govern a variety of other exchanges involving inbound transfers of property made by foreign corporations. The principal purpose of these provisions is to preserve the ability of the United States to tax, either currently or at some future date, the earnings and profits of a foreign corporation attributable to shares owned by U.S. shareholders. As with the outbound acquisition rules, the failure to require an inclusion of a dividend for a foreign corporation’s earnings and profits would allow the foreign corporation’s earnings and profits to avoid the U.S. taxing jurisdiction forever. When a U.S. C corporation receives the dividend, the U.S. C corporation will be entitled to the benefits of indirect foreign tax credits, which may shelter any additional U.S. tax. To the extent the dividend is received by a U.S. individual, the dividend will be taxed at only 15 percent. Provisions similar to those governing inbound repatriating liquidations of foreign subsidiaries also govern a variety of other exchanges involving transfers of property from one foreign corporation to another foreign corporation. The principal purpose of these provisions is to preserve the ability of the United States to tax, either currently or at some future date, the earnings and profits of a foreign corporation attributable to shares owned by U.S. shareholders. The inclusion of a dividend typically occurs when a U.S. shareholder of a CFC exchanges shares of the CFC for shares of a foreign corporation whereby the U.S. person is not a U.S. shareholder of a CFC. When a U.S. C corporation receives the dividend, the U.S. C corporation will be entitled to the benefits of indirect foreign tax credits, which may shelter any additional U.S. tax. To the extent the dividend is received by a U.S. individual, the dividend will be taxed at only 15 percent. Suggested Internal Revenue Code Section: 367


The common treaty provisions.

Disclosure of treaty-based return positions.

Outbound transfers of property to foreign corporations.

Acquisitive reorganizations.

Outbound transfers in an acquisitive reorganization.

Anti-inversion provisions of Code Sec. 7874.

Inbound liquidation of a foreign subsidiary into its domestic parent.


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Inbound transfers in an acquisitive reorganization.

Foreign-to-foreign transfers in an acquisitive reorganization.


Suggested reading: United States Model Income Tax Convention of November 15, 2006





1. Stoolco, a domestic corporation, produces a line of low cost bar stools at its facilities in Missouri for sale throughout the United States. During the current year, Stoolco’s management has decided to begin selling it stools overseas and has begun exploring the idea of establishing branch sales offices in some key countries in Europe and Asia. If possible, Stoolco’s management would like to avoid establishing a taxable presence in these countries. Stoolco’s management has asked you to advise them on the types of marketing activities they can conduct within these countries without creating a taxable nexus. For purposes of this analysis, assume that the United States has entered into an income tax treaty with the countries in question that is identical to the United States Model Income Tax Convention of November 15, 2006.

2. Erica is a citizen of a foreign country, and is employed by a foreign-based computer manufacturer. Erica’s job is to provide technical assistance to customers who purchase the company’s mainframe computers. Many of Erica’s customers are located in the United States. As a consequence, Erica consistently spends about 100 working days per year in the United States. In addition, Erica spends about 20 vacation days per year in Las Vegas, since she loves to gamble and also enjoys the desert climate. Erica does not possess a green card. Assume that the United States has entered into an income tax treaty with Erica’s home country that is identical to the United States Model Income Tax Convention of November 15, 2006.

How does the United States tax Erica’s activities? How would your answer change if Erica were a self-employed technician rather than an employee? 3. Finco is a wholly owned Finnish manufacturing subsidiary of Winco, a domestic corporation that

manufactures and markets residential window products throughout the world. Winco has been Finco’s sole shareholder since Finco was organized in 1990. At the end of the current year, Winco sells all of Finco’s stock to an unrelated foreign buyer for $25 million. At that time, Finco had $6 million of post-1986 undistributed earnings, and $2 million of post-1986 foreign income taxes that have not yet been deemed paid by Winco. Winco’s basis in Finco’s stock was $5 million immediately prior to the sale.


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Assume Winco’s capital gain on the sale of Finco’s stock is not subject to any foreign taxes, and that the U.S. corporate tax rate is 35%. What are the U.S. tax consequences of this sale for Winco? Now assume that instead of selling the stock of Finco, Winco completely liquidates Finco, and receives property with a market value of $25 million in the transaction. As in the previous scenario, at the time of the liquidation, Finco had $6 million of accumulated earnings and profits, and $2 million of foreign income taxes that have not yet been deemed paid by Winco. Assume that Winco’s basis in Finco’s stock was $5 million immediately prior to the liquidation, and that the U.S. corporate tax rate is 35%. What are the U.S. tax consequences of this liquidation for Winco?


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Lesson 8 – State and International Taxation

Introduction This lesson begins with an examination of how the United States taxes foreign corporations and nonresident aliens who derive U.S. source investment-type income. Forty-four states and the District of Columbia impose a net income tax on corporations, with tax rates ranging from roughly 4% to 12%. Federal tax law plays an important role in state taxation of a domestic corporation’s foreign earnings because most states use either federal taxable income before the net operating loss and dividends-received deductions (federal Form 1120, line 28) or federal taxable income (federal Form 1120, line 30) as the starting place for computing state taxable income. States employ a wide variety of consolidation rules for a group of commonly controlled corporations. A handful of states require each group member that is taxable in the state to file a return on a separate company basis. About 25 states permit a group of commonly controlled corporations to elect to file a state consolidated return, but only if certain requirements are met. About 20 states require members of a unitary business group to compute their taxable income on a combined basis. Roughly speaking, a unitary business group consists of two or more commonly controlled corporations that are engaged in the same trade or business, as exhibited by such factors as functional integration and centralized management. In those states that require combined unitary reporting, there are two approaches to dealing with unitary group members that are incorporated in a foreign country or conduct most of their business abroad. One approach is a worldwide combination, under which the combined report includes all members of the unitary business group, regardless of the country in which the group member is incorporated or the country in which the group member conducts business. The alternative approach is a water’s-edge combination, under which the combined report excludes group members that are incorporated in a foreign country or conduct most of their business abroad. Most states allow corporations to claim some form of dividends-received deduction with respect to dividends received from other corporations, and states generally extend their dividends-received deductions to dividends received from foreign corporations. If a domestic corporation operates abroad through an unincorporated foreign branch rather than a separately incorporated subsidiary, the foreign-source income of the branch represents income earned directly by the domestic corporation. States generally conform to the federal check-the-box rules for income tax purposes. Thus, a foreign entity that is a corporation for foreign tax purposes but is a branch or partnership for U.S. federal tax purposes is generally treated as a branch or partnership for state income tax purposes. Although the states generally do not permit a corporation to claim a credit for foreign income tax payments, some states allow a corporation to deduct its foreign income taxes. However, the allowance of the deduction is generally predicated on whether the corporation elects to deduct the foreign income taxes for federal tax purposes. A handful of states allow a state deduction when the taxpayer claims the credit for federal purposes. This lesson concludes with an overview of international tax practice and procedures. While many of the same procedural issues present in audits of domestic businesses are germane, there are other unique


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problems facing U.S.-based multinationals (outbound investment) as well as U.S. subsidiaries of foreign parent companies (inbound investment). Organization of the Internal Revenue Service International Offices. — The office of Assistant Commissioner (International) in Washington, D.C. functions as the U.S. competent authority. The international examiners are assigned to the industry groups within the Large and Mid-Size Business Division and the Office of Appeals. The IRS has retrained many of its agents as international examiners. Due to the increased emphasis by the IRS on intercompany transfer pricing, IRS economists are also becoming involved in the audit process. The primary authority for recordkeeping requirements of an entity potentially liable for U.S. tax is Code Sec. 6001 of the Internal Revenue Code and the related Regulations. The IRS also has the specific authority to examine any books, papers, records or other data that may be relevant or material to ascertaining the correctness of any return, determining the tax liability of any person or collecting any tax. At the conclusion of the examination, the international examiner will prepare a report summarizing the findings. The report is then incorporated into the field agent’s report. Any disputed issues from the international examiner’s report may be pursued with the Appeals Office along with other domestic issues raised during the examination. Upon completion of an international examination, the examining office may issue the taxpayer a thirty-day letter proposing a deficiency. The taxpayer may object to any proposed tax adjustments and request a conference with the Appeals Office by filing a protest with the Appeals Office. The taxpayer must formally request the conference by means of a document known as a protest. Generally, if the taxpayer has been unable to agree with the Appeals office on an adjustment that results in double taxation, the next course of action is to seek competent authority relief. An integral part of all U.S. Income Tax Treaties is a mutual agreement procedure which provides a mechanism for relief from double taxation. The Assistant Commissioner (International) acts as the U.S. competent authority. A taxpayer may contest an adverse IRS determination in one of three tribunals. A petition may be filed with the U.S. Tax Court, and assessment and collection of the deficiency will be stayed until the Court’s decision becomes final. Alternatively, the taxpayer may pay the deficiency including interest and penalties and sue for a refund in a U.S. District Court or the U.S. Court of Federal Claims. Suggested Internal Revenue Code Sections: 982; 6038A and 7602.


Overview of state corporate income taxes.

Worldwide versus water’s-edge combined reporting.

Dividends from foreign subsidiaries.

Check-the-box foreign branches.

Treatment of foreign income tax payments.


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State versus federal nexus standards for foreign corporations.

Organization of the Internal Revenue Service international offices.

International examinations.

The appeals division of the IRS.

Civil actions by taxpayers.




If you use an online source to support your answers, you must provide a properly formatted link to the source. Make sure your sources are credible. Assignment Questions

1. For purposes of computing a corporation’s state taxable income, do states generally permit a U.S.

parent corporation to claim a dividends-received deduction for dividends received from a foreign country subsidiary?

2. USAco wholly owns a foreign subsidiary in Hong Kong called HKco. USAco sells HKco the seven components necessary to make sunglasses. Following one page of directions written in Chinese, HKco employees put the components together to make the sunglasses for HKco’s sale throughout Europe. In order to determine whether USAco has any foreign base company sales income under Subpart F, the IRS needs to analyze whether HKco’s activities constitute manufacturing. What procedures can the IRS employ to gather the information needed to make this determination?

3. USAco is the wholly-owned U.S. subsidiary of ASIAco and USAco purchases automobiles from

ASIAco for $20,000. USAco resells the automobiles for $21,000. The IRS conducts a transfer pricing examination of USAco and proposes an adjustment based on what it believes to be the arm’s length transfer price of $15,000. USAco decides to pursue the issue at both Appeals and Competent Authority under the Simultaneous Appeals Procedure (“SAP”). Describe the SAP procedures.

Documents

Fundamentals of International Taxation