I NTRODUCTION TO I NTERNATIONAL T AXATION US International Tax Framework and Structuring Foreign Operations PwC

INTRODUCTION TO INTERNATIONAL TAXATION

US International Tax Framework and Structuring Foreign Operations

PwC

MODULE OBJECTIVES

Upon completion of this module, participants will (be able to): Describe the basic principles of US taxation of US multinationals

with foreign activities and foreign multinationals with US activities Recognize that the form of doing business abroad is likely to

change over time as a US company expands its foreign operations Discuss the general tax implications of operating abroad through

exporting, licensing, branches, partnerships, or foreign subsidiaries Explain the use of the "check-the-box" regulations in classifying

entities Identify the conditions that create a foreign income tax exposure Recognize that several foreign currency rules apply to income from

exporting or operating branches Describe the implications of transfer pricing rules Identify the general US tax implications of cross-border M&A

transactions

U.S. INTERNATIONAL TAX FRAMEWORK

The US uses a “hybrid” taxing system related to cross-border income/taxpayers Worldwide Income/Tax Credit System

Applicable to US persons Worldwide income subject to tax Potential double taxation primarily mitigated with a

foreign tax credit Territorial system

Applicable to non-US persons Only certain income earned from US activities is

subject to US taxation

U.S. INTERNATIONAL TAX FRAMEWORK (CONT’D)

US Source Income

Type of Person

U.S. Foreign

Potentially Taxed in U.S.

Foreign Source Income

Generally taxed only in foreign jurisdiction

Taxed in U.S.

US Source Income Foreign Source Income

Taxed in both U.S. and foreign jurisdiction

Foreign Tax Creditallowed

“Outbound”

“Inbound”

TAXATION OF FOREIGN PERSONS WITH U.S. CONNECTED INCOME

U.S. source “investment” income Taxed on gross income with no deductions permitted Taxed at a 30% rate via withholding unless reduced by

a tax treaty U.S. source trade or business income

Deductions are permitted Taxed at progressive rates Potential branch level taxes

TAXATION OF FOREIGN PERSONS WITH US CONNECTED INCOME: “INBOUND” TAXATION

ForCo

US source investment income• US withholding tax• Local country income tax

US source income from business operations

• US income tax• US branch level taxes• US withholding taxes• Local country income tax

TAXATION OF U.S. PERSONS WITH FOREIGN INCOME: “OUTBOUND” TAXATION

USCo

Foreign source investment income• US income tax• Local country withholding tax

Foreign source income from business operations

• US income tax• Local country income tax• Local country withholding tax

US OUTBOUND EXAMPLE

USCorporation(35% tax)

ForeignBranch

(30% tax)

$1,000 US Source Net Income

US Corporate Tax Return – Form 1120

$600 Foreign Source Net Income(subject to tax in both the US and foreign jurisdiction)

US TAXATION – ASSUMING NO FTC OR DEDUCTION FOR FOREIGN TAXES

US Tax Return Foreign Country Tax Return

US Source Income


Taxable Income

US Income Tax

$1,000

600

$1,600

x .35

$ 560


Taxable Income

Foreign Income Tax

$600

$600

x .30

$180

US TaxForeign TaxWorldwide Tax

Worldwide ETR

$560180

$740

46.25% [$740/$1,600]

US TAXATION – WITH DEDUCTION FOR FOREIGN TAXES


US Source Income


Deduction for Foreign Tax

Taxable Income

US Income Tax

$1,000

600

-180

$1,420

x .35

$ 497


Taxable Income

Foreign Income Tax

$600

$600

x .30

$180


Worldwide ETR

$497 180$677

42.30% [$677/$1,600]

US TAXATION – WITH FTC


US Source Income


Taxable Income

US Income Tax (before FTC)

Less FTC

US Income Tax (after FTC)

$1,000

600

$1,600

x .35

$ 560

-180

$380


Taxable Income

Foreign Income Tax

$600

$600

x .30

$180


Worldwide ETR

$380 180$560

35% [$560/$1,600]

Structuring Foreign Operations

TAX ISSUES IN STRUCTURING FOREIGN OPERATIONS

Form of doing business (method/entity choice) Foreign income tax exposure

Activities in foreign jurisdiction that give rise to an income tax exposure

Permanent establishment (PE) under an income tax treaty

Foreign currency implications from foreign operations

US and foreign transfer pricing policy and compliance requirements

US income tax implications of creating foreign entities, transferring assets outside the US, and other cross-border transactions

STRUCTURING OF FOREIGN OPERATIONS:OVERALL OBJECTIVES

Global Tax Optimization (subject to business goals)

Where do we want to put our profit? Profit Drivers:

Assets Functions Risk

Which drivers attract the most profit?

GOING GLOBAL OVER TIME

Domestic Operation Only

Export License to Foreign Person

Foreign Branchor Partnership

Separate Foreign Entity

Current U.S. Taxation Potential Deferral

Time

FORMS OF DOING BUSINESS AND THE U.S. TAX EFFECTS

Type of Entity US Taxation? Timing of US Taxation

Export Full Current inclusion

License Full Current inclusion

Branch Full Current inclusion

Partnership Full Current inclusion

Foreign Corporation Only upon repatriation or deemed inclusion

Deferral (but Subpart F, 956 income, and other provisions may require current inclusion)

CRITERIA FOR SELECTION OF METHOD/ENTITY

Method/Entity choice is often the result of a "growth process“ as a business becomes more global in scope

Key factors: business objectives benefit from partnering with foreign 3rd parties need to protect intangible property or know-how projection of operating results expected repatriation demands type of income to be earned exposure to foreign income tax availability of treaty benefits

Exposure to Foreign Income Tax

EXPOSURE TO FOREIGN INCOME TAX

US firms generally face exposure to foreign income taxes when their activities in the foreign jurisdiction rise to the level of a “trade or business” within that jurisdiction

This concept is similar to “nexus” in a multi-state context

When income tax treaties exist, the generic “trade or business” concept is replaced with the more formal definition of a permanent establishment

PERMANENT ESTABLISHMENT

The Permanent Establishment (PE) tax treaty concept is similar to “trade or business” but allows more activities without giving rise to an income tax exposure in the jurisdiction

A PE generally is created by a fixed place of business

Fixed place of business includes: place of management branch office factory workshop

PERMANENT ESTABLISHMENT (CONT’D)

Permanent Establishment typically excludes: Facility for maintenance of goods solely for

storage, display or delivery Maintenance of a fixed place of business solely

for carrying on activities that are preparatory or auxiliary in nature

Temporary construction project Engagement of broker or agent of independent

status Subsidiary of parent unless parent carries on

business itself

Form of Doing Business Abroad

GOING GLOBAL - EXPORTING No separate entity required No deferral Foreign tax exposure

Customs/VAT/GST taxes Not available for use as FTCs

Typically no foreign income tax exposure if only exporting activity Income tax treaty (if applicable) provides more

certainty under the PE article than reliance on local country law to determine income tax exposure

Potential foreign currency implications - §988

GOING GLOBAL - LICENSING No separate entity required No deferral Foreign tax exposure

Foreign withholding taxes on royalties Income tax treaties (when applicable) reduce

withholding rates (often to zero) Withholding taxes available as FTCs on US tax return

Typically no foreign income tax exposure (other than withholding taxes) for US company itself if only licensing in the jurisdiction

Potential foreign currency implications - §988

GOING GLOBAL - BRANCH No separate entity required

Note applicability of “check-the-box” rules in determining whether a foreign entity is a branch or separate corporation

No deferral / Flow through of foreign losses (but see DCL issue discussed in course text material)

Foreign tax exposure Typically the US corporation is liable for foreign income

taxes on net profits associated with foreign branch Typically the branch activities will constitute a PE under any

applicable income tax treaty Foreign income taxes available as FTCs on US return Foreign jurisdiction transfer pricing issues in determining

foreign net profit Potential foreign currency implications - §987

GOING GLOBAL - PARTNERSHIP Formal or informal partnership agreement

Note applicability of “check-the-box” rules in determining whether a foreign entity is a partnership or separate corporation

No deferral Foreign tax exposure

Typically the US person is liable for foreign income taxes on net profits associated with foreign partnership

Typically the partnership activities will constitute a PE to the US partner under any applicable income tax treaty

Foreign income taxes available as FTCs on US return

Foreign jurisdiction transfer pricing issues in determining foreign net profit

Potential foreign currency implications - §§987 & 988

GOING GLOBAL – FOREIGN SUBSIDIARY

Separate legal entity created Note applicability of “check-the-box” rules in determining whether

a foreign entity is a branch/partnership or separate corporation Potential US tax implications in creating foreign subsidiary - §367 No current US tax (deferral) absent Subpart F, §956, etc. US (and foreign) transfer pricing issues on related party transactions Foreign tax exposure

Typically the US owner is not liable for foreign income taxes on net profits associated with the foreign subsidiary (the subsidiary itself files a local country tax return and pays foreign taxes)

Foreign income taxes available as §902 FTCs on US return when profits repatriated via dividends

Potential foreign currency implications - §§986 & 989

Foreign Currency Issues

PURPOSE OF FOREIGN CURRENCY RULES

Operations conducted through foreign branch or subsidiary usually denominated in a foreign currency

When results of foreign operations are included in the US tax return, they must be reported in US dollars Income and expenses Gains and losses Foreign income taxes Foreign withholding taxes

KEY CURRENCY STATUTORY AUTHORITY Definitions

Functional currency - §985

QBU - §989 Appropriate exchange

rate - §989

Branch Transactions (§987) Taxable income or loss Transfers of branch

property Foreign exchange

“exposure pool method” Disposition/Termination

of branches

Foreign Taxes & Transactions with Foreign Corporations (§986) E&P pools Dividends and

associated§902 FTCs

Previously taxed E&P (PTI)

Foreign tax pools

KEY CURRENCY STATUTORY AUTHORITY (CONT’D)

§988 Transactions – taxed as ordinary income Taxpayer acquires and disposes of instruments

denominated in a nonfunctional currency or instruments determined by reference to the value of a nonfunctional currency (§988 transactions)

Taxpayer acquires or becomes the obligor under a debt instrument

Taxpayer enters into or acquires any forward or futures contract, option, or any similar financial instrument

Taxpayer holds foreign currency as an investment or enters into a foreign exchange contract (hedging)

KEY ISSUES IN FOREIGN CURRENCY TRANSLATION

When are transaction results translated?Transaction by transaction--nonfunctional currency

Net profit or loss method--functional currencyForeign exchange “exposure pool method”

BASIC PRINCIPLES

For US income tax purposes, a taxpayer and each “qualified business unit” (QBU) must make all of its determinations in its “functional currency” - §985(a)

Functional currency is the currency of the “economic environment” in which a significant part of the QBU’s activities are conducted, and which is used by the QBU in keeping its books and records

Implications of Transfer Pricing

WHY IS TRANSFER PRICING IMPORTANT?

Virtually all ITS strategies require effective use of transfer pricing strategies to optimize a company’s global effective tax rate

Every jurisdiction wants to tax a portion of an entity’s income Risk of double taxation (two or more countries want to

tax the same income) Transfer pricing penalties have been enacted by the US

and all major U.S. trading partners

SECTION 482

In any case of two or more organizations, trades, or businesses (whether or not incorporated, whether or not organized in the United States, and whether or not affiliated) owned or controlled directly or indirectly by the same interests, the Secretary may distribute, apportion, or allocate gross income, deductions, credits, or allowances between or among such organizations, trades, or businesses, if he determines that such distribution, apportionment, or allocation is necessary in order to prevent evasion of taxes or clearly to reflect the income of any of such organizations, trades, or businesses. In the case of any transfer (or license) of intangible property (within the meaning of section 936(h)(3)(B)), the income with respect to such transfer or license shall be commensurate with the income attributable to the intangible.

WHAT DOES TRANSFER PRICING APPLY TO?

Tangible goods Financing

Intercompany loans, accounts receivable, guarantees Services

Management fees, potential transfer of intangibles Intangibles

Royalties, cost sharing, buy-in payments, sale of intangible

TRANSFER PRICING PENALTIES - REG. §1.6662-6

The regulations encourage taxpayers to: Make a serious effort to comply with the arm’s

length standard in setting prices for controlled transactions

Report an arm’s length result on their income tax return

Document their transfer pricing analysis Provide documentation to the IRS upon request

KEY TRANSFER PRICING PENALTIES

Substantial Valuation Misstatement 20 percent of additional tax

Gross Valuation Misstatement 40 percent of additional tax

Treas. Reg. §1.6662-6

INTRODUCTION TO INTERNATIONAL TAXATIONForeign Tax Credit

PwC

Foreign Tax Credit Overview

METHODS FOR AVOIDANCE OF DOUBLE TAXATION

Exclusion of non-U.S. source income (e.g., §911) Deduction for foreign taxes - §164(a)(3) Income tax treaty arrangements Foreign tax credit - §§901 - 907

DEDUCTION VS. CREDIT FOR FOREIGN TAXES

Annual election to claim a credit or a deduction – Form 1118 or 1116

Must be consistently applied in any one year 10 year statute of limitations (not 3 years)

Permits taxpayers to claim credit or deduction based on subsequent events

Reg. §1.901-1(d) and §6511

SITUATIONS WHEN CLAIMING FOREIGN TAXES AS DEDUCTIONS MAY BE MORE ADVANTAGEOUS

U.S. taxpayer has a Net Operating Loss and credits would expire unutilized Foreign tax Credit - 1 year carryback and 10 year

carryforward - §904(c) Carryback is not elective Carryovers are applied on a FIFO basis, with the

current year FTC being used first Short tax years count as full years for carryover

purposes A year in which the taxpayer elects to deduct

foreign taxes counts in the carryover period Net Operating Loss - 2 year carryback and 20 year

carryforward Taxpayer is limited in the amount of foreign taxes

which may be claimed as a credit Often caused by substantial expense apportionment

against foreign source income (as discussed later)

TYPES OF FOREIGN TAX CREDITS

Direct credit - §901 “In lieu of” credit - §903 Deemed paid (indirect) credit - §902 and §960

WHO CAN CLAIM A FOREIGN TAX CREDIT?

US persons For conduit entities: partners, S Corp.

shareholders, and trust and estate beneficiaries (if otherwise qualified)

Resident aliens Foreign persons conducting a U.S. trade or

business §§901(c) and 906

WHEN TO CLAIM THE CREDIT

Allowable when “paid or accrued” - §905(a) Cash method taxpayer

When paid A cash method taxpayer can elect to use the accrual

method Accrual method taxpayer

Taxes are creditable when the “all events” test is met and the amount and liability are fixed

File Form 1118 (corporations) or 1116 (individuals)

Proof of credits (foreign taxes) - §905(b)

TRANSLATING FOREIGN TAXES - §986(A)

Cash method taxpayers Use the spot rate on the date the tax was paid (or

withheld) Accrual method taxpayers

Use the average exchange rate for the year to translate all taxes for the year Withholding taxes Estimated tax payments Taxes accrued at year-end Election to use the spot rate is allowed for taxes

paid in non-functional currency - §986(a)(1)(D) & (E)

FTC LIMITATION FORMULA - §904

Foreign Foreign SourceTax = Taxable Income US TaxCredit Within Basket x Before FTCLimit Total Taxable Income

Allowed FTC is the lesser of:Creditable foreign income taxes -§§901 –

903FTC limit - §904

See Form 1118

Creditable Foreign Taxes

CREDITABLE TAXES - REQUIREMENTS OF A CREDITABLE TAX

In general §901(b) allows a credit against U.S. income tax for "any income, war profits and excess profits tax paid or accrued...to any foreign country or to any possession of the United States"

§903 states that the term "income, war profits, and excess profits taxes" shall include a tax paid "in lieu of" an income tax

REQUIREMENTS OF A CREDITABLE TAX (CONT’D) A foreign levy is a creditable income tax if:

it is a tax; it requires a compulsory payment

a penalty, fine, interest or similar obligation is not a tax, neither is a customs duty a tax

must exhaust all effective and practical remedies, including the invocation of competent authority

must be paid to a foreign government without receipt or consideration of a direct or indirect specific economic benefit;

the predominant character of the tax is an income tax in the US sense

Whether a foreign levy is an income tax is determined independently for each separate levy

Reg. §1.901-2

REQUIREMENTS OF A CREDITABLE TAX (CONT’D)

Reg. §1.901-2(b)(1) requires that the tax have the predominant character of an “income tax in the U.S. sense” Realization Gross receipts Net income

Issue of “technical taxpayer” can arise in determining who is eligible for the credit [beyond scope of course]


Realization test - Reg. §1.901-2(b)(2) The tax must be imposed when “net gain” is “realized”

in the US sense The tax must be imposed as the result of a

“transaction” Gross receipts test - Reg. §1.901-2(b)(3)

The tax is imposed on net gain attributable to actual gross receipts

The test may be satisfied if the government uses a formula to approximate gross receipts provided the result is not greater than the fair market value of the services provided by the taxpayer


Net income test - Reg. §1.901-2(b)(4) The tax is imposed on gross receipts less significant

costs and expenses Costs include capital expenditures (depreciation). Allowances are acceptable if the resulting tax base

approximates net income

“IN LIEU OF” INCOME TAX – §903

The tax must substitute for the general income tax. The charge must approximate the tax that would result

under the general income tax Withholding taxes imposed on gross receipts

generally qualify as “in lieu of” income taxes Withholding taxes are imposed for administrative

convenience

NON-CREDITABLE FOREIGN TAXES

Non-income taxes (property taxes, excise taxes, VAT, etc.)

Subsidies Any benefit conferred, directly or indirectly, by the

foreign country to the taxpayer - Reg. §1.901-2(e)(3)(ii) Taxes paid to “§901(j) countries”

Cuba, Iran, North Korea, etc. Soak-up taxes

A foreign tax is not a creditable income tax to the extent it would not be imposed but for the availability of an income tax credit of another country - Reg. §1.901-2(c)

§902 Indirect Foreign Tax Credits

DEEMED PAID FTC: EXAMPLE (BRANCH WITH DIRECT TAX)

If a US corporation earns foreign income through a branch, the US corporation pays the foreign tax directly and receives a credit under Sec. 901 (i.e., a direct credit)

US corporation will include $1,000 in gross income and claim a foreign tax credit of $250, subject to any limitation

US Corp

ForeignBranch

Foreign Income 1,000€Foreign Tax $ 250

Assume $1 : 1€

DEEMED PAID FTC: EXAMPLE (FOREIGN SUBSIDIARY)

If a US corporation earns foreign income through a sub and repatriates all the after-tax profits, the US corporation has not directly paid any foreign taxes and thus can’t receive a Sec. 901 FTC

However, under §902, the US corporation will treat the $250 of taxes paid by the foreign sub as a FTC in the U.S.

US corporation will include the $1,000 in gross income ($750 dividend plus $250 §78 gross-up) and claim a foreign tax credit of $250, subject to any limitation

US Corp

ForeignSub

Foreign Income 1,000€Foreign Tax $ 250Foreign E&P 750€

Assume $1 : 1€

$750Dividend

FTC - DEEMED PAID TAX CALCULATION

Dividend* or“Deemed Dividend”* Post-86 Foreign = §902 FTCPost-86 Undistributed x Tax Pool Earnings

* before §78 gross-up

Functional Currency US Dollar

FOREIGN CURRENCY ISSUES Foreign taxes translated each year into U.S.

dollars using the appropriate rate - §986(a) Foreign corporation E&P is maintained in

functional currency - §986(b)(1) Ratio of dividend to undistributed earnings is

determined with both amounts in functional currency Actual dividend distribution is translated at spot

rate - §989(b)(1) Consequently, no FX gain or loss is triggered with

actual dividend distributions (i.e., income inclusion and translation occur at the same time)

Sourcing Income and Expenses

PURPOSE OF SOURCING RULES

Sourcing Rule

Gross Income

U.S. S

ource

Foreign Source

/ Bask

et

PURPOSE OF SOURCING RULES (CONT’D)

Allocation & ApportionmentSourcing Rules

Gross Income Deductions

U.S. S

ource

U.S. S

ource

Foreign Source

/ Bask

et

Foreign Source

/ Bask

et

SOURCING IMPLICATIONS – U.S. PERSONS

FTC Limitation = Foreign Source Taxable Income (within Basket)

Total Taxable Income

x U.S. Income TaxBefore FTC

Determination of FTC limitation - §904

U.S. FRAMEWORK FOR SOURCING GROSS INCOME

Predominant Situs Residence of Recipient

Split Source

PREDOMINANT SITUS

Income classified based on the location of the economic activity that produced the income

Examples include interest, dividends, personal services income, rents, royalties, sale of real property, sale of certain personal property, certain transportation income, insurance underwriting income, and social security benefits

RESIDENCE OF RECIPIENT

Income classified based on the residence of the recipient

Examples include sale of personal property other than inventory, ocean or space income, and certain foreign currency gains and losses

SPLIT SOURCE

Income classified as part U.S. source and part foreign source using a statutory or regulatory formula

Examples include transportation and international communications income

PROCESS FOR SOURCING GROSS INCOME

Step #1

Determine gross income category

Step #2

Apply category specific source rule

GROSS INCOME - STATUTORY CATEGORIES

Interest §§861(a)(1) and 862(a)(1)

Dividends §§861(a)(2) and 862(a)(2)

Personal services income §§861(a)(3) and 862(a)(3)

Rentals and royalties §§861(a)(4) and 862(a)(4)

Disposition of U.S. real property interests §861(a)(5)

Sale of inventory §§861(a)(6), 862(a)(6), and 863

Sale of personal property other than inventory §865

Insurance underwriting income §§861(a)(7) and 862(a)(7)

Social Security benefits §861(a)(8)

ROADMAP TO SOURCE OF INCOME RULES

§861 provides primary rules on sourcing gross income by indicating what constitutes US source income

§862 indicates that foreign source income for the items listed in §861 are simply all items that are not US source

§863 delineates the sourcing of Income derived partly within and partly from without

the U.S. - §863(b) inventory sales Transportation income Space and certain ocean activities income International communications income

ROADMAP TO SOURCE OF INCOME RULES (CONT’D)

§864 contains definitions and special rules “Defines” trade or business within United States Defines effectively connected Income Certain rules for allocating interest and other

expenses §865 contains detailed rules on the source of

income form the sale of personal property General rule - Source of income determined by

reference to the residence of the seller Inventory - §§861(a)(b), 862(a)(b) and 863 Depreciable personal property (depreciation

recapture) Intangible assets (treated as a royalty if

payments are contingent upon) Stock of 80% owned affiliates Sales through offices or fixed places of business

INTEREST INCOME

General rule - Sourced according to the residence of the payer §§861(a)(1) and 862(a)(1) See §7701 to determine residence

Major exceptions Interest from foreign branch of US bank US “80-20” company (proposed repeal by “Green

Book”) Special rules for payments of interest by a U.S. branch

of a foreign corporation [§884] or certain foreign partnerships [§861(a)(1)(C)]

INTEREST FROM FOREIGN BRANCH OF US BANK

Interest paid on deposits with a foreign branch of a US corporation or partnership is treated as foreign source income if the branch is engaged in the commercial banking business - §861(a)(1)(B)(i)

As long as the interest income is not effectively connected with a US trade or business, no US withholding tax is imposed on the interest payments - §871(i)(2)(A) and §881(d)

DIVIDEND INCOME

General rule - dividends are sourced according to the residence of the payer §§ 861(a)(2) and 862(a)(2)

Exceptions 25% Look-through rule for foreign corporations with US

trade or business U.S. withholding tax on such U.S. source income is

repealed effective for payments after 12/31/2004 US “80-20” Company (proposed repeal)

PERSONAL SERVICES INCOME

Personal services income is sourced based on where the services are performed - §861(a)(3) and §862(a)(3) Services performed both within and outside the U.S.

generally must be allocated based on time spent - Treas. Reg.§1.861-4(b)(1)(i)

There is a de minimis rule for nonresident aliens who work temporarily in the United States (the so-called “commercial traveler” exception)

RENT INCOME

In general, rental income is sourced based on the place where the property is located or used - §861(a)(4) and §862(a)(4)

The taxpayer must apportion the rental income on the basis of time, mileage, or some other appropriate base, if the property is used both inside and outside the US

ROYALTY INCOME

Royalty income generally is sourced based on the place where the intangible property is used - §861(a)(4) and §862(a)(4)

Intangibles include patents, copyrights secret processes, know-how, customer lists, goodwill, trademarks, trade brands (see also §197 and §936(h)(3)(B) for other types of intangibles)

COMPUTER SOFTWARE INCOME

“Licensing’ of computer software to a customer in exchange for a “royalty” might constitute a royalty, rental income from the lease of the diskette/program, or sales proceeds from the sale of the diskette/program

Regulations provide guidance on classifying transactions that involve computer programs -Reg.§1.861-18

REAL PROPERTY INCOME

In general, gains from the sale or exchange of real property are sourced according to the location of the property - §861(a)(5)

Special rules with regard to the Foreign Investment in Real Property Tax Act of 1980 (FIRPTA) - §897 (as discussed in later module)

PERSONAL PROPERTY OTHER THAN INVENTORY

General rule - Gain from the sale or exchange of personal property other than inventory is sourced according to the residence of seller - §865(a) Numerous exceptions exist within §865

US citizens or resident aliens are residents of the United States for this purpose unless they have a “tax home” in a foreign country, in which case gains will still be US source unless an income tax of at least 10% of the gain is actually paid to a foreign country - §865(g)(1) and (2)

INVENTORY INCOME

Purchased Inventory Gross income from the sale of inventory purchased for

resale is sourced on the basis of where the sale occurs, i.e., “the title passage rule” - §861(a)(6) and §862(a)(6)

Manufactured inventory Source partially within the US and partially without the

US Referred to as “§863(b) income” General rule is the 50-50 method - Reg. § 1.863-3

Source based on property factor and sales factor Can elect to use the “Independent Factory Price”

Allocation & Apportionment of Expenses

ALLOCATE VS APPORTION DEDUCTIONS

Step 1 – Allocate to class of gross income Step 2 – Apportion between statutory and

residual groupings Reg. § 1.861-8

ALLOCATION

Absent any special rules, allocate deductions to a class of gross income that represents a specific income-producing activity or property

A deduction is allocated to a class if it is definitely related to a class of gross income Deduction is definitely related if “incurred as a result of

or incident to” the activity or property that gave rise to the gross income - Reg. §1.861-8(a) and (b)

A deduction may be definitely related to all of the taxpayer’s gross income - §1.861-8(b)(5)

APPORTIONMENT

After allocation among gross income, deductions within a class of income are then apportioned to statutory groupings and residual groupings based on any reasonable method - Reg.§1.861-8T(c)(1) Statutory grouping is gross income that, when reduced by

deductions, becomes relevant under a particular operating provision (e.g., foreign source income within a basket when computing the foreign tax credit) - Treas. Reg.§1.861-8(a)(4)

Residual grouping is the remaining gross income not included in the statutory grouping

Expenses must be apportioned to US and foreign sources on a basis that “reflects to a reasonably close extent the factual relationship between the deduction and the grouping of gross income” - Reg.§1.861-8T(c)(1)

The effect of an apportionment on the taxpayer’s tax liability and record-keeping burden is considered when determining whether an apportionment is sufficiently accurate - Reg.§1.861-8T(c)(1)

EXPENSES RELATED TO ALL GROSS INCOME

SG&A expenses may be apportioned based on any reasonable method

Taxpayers have some flexibility here because the factual relationship between SG&A expenses and income is usually subjective

EXPENSES NOT DEFINITELY RELATED TO ANY GROSS INCOME

Deductions not definitely related to any gross income are apportioned between statutory and residual groupings based on gross income - Reg.§1.861-8(c)(3)

Examples include Real estate taxes on a personal residence Medical expenses Charitable deductions Alimony See Reg. §1.861-8(e)(9)

RESEARCH AND EXPERIMENTAL EXPENSE (R&D)

US corporations must allocate and apportion research costs to foreign source income if the corporation has foreign sales or gross income - Reg. §1.861-17

This apportionment is required without regard to where the R&D activity is performed

FTC Limitation

FTC FORMULA: SEPARATE BASKETS

Foreign Foreign SourceTax = Taxable Income US TaxCredit Within Basket x Before FTCLimit Total Taxable Income

FTC - IMPACT OF BASKETS

Baskets limit the ability to “cross credit” foreign taxes on high-taxed foreign source income against US residual tax on low-taxed foreign source income

Planning objective is to mix high- and low-taxed foreign source income within same basket

FTC - SEPARATE BASKETS - § 904

For tax years beginning after 12/31/2006 Passive Income (i.e. interest, rents, royalties, etc.) All other income (i.e., the “general” basket)

Note that carryforwards from pre-2007 baskets were assigned to either the passive or general basket as appropriate

PASSIVE INCOME BASKET Passive income is any income that meets the

definition of foreign personal holding company income - §954(c)

Passive income generally includes: Dividends Interest Rents Royalties Annuities Gains from sale of property Net commodities gains Net foreign currency gains

PASSIVE BASKET “KICK-OUTS” - §904(D)(2)

Certain passive income is “kicked out” of the passive basket and into the general limitation basket Export financing interest High-taxed income (passive income subject to an

average foreign tax rate exceeding the top U.S. marginal tax rate)

Rents and royalties derived from the active conduct of a trade or business

GENERAL LIMITATION INCOME BASKET

The general limitation basket is the residual basket for all other “unclassified” income

General limitation income includes Active trade or business income (high and low taxed) Export financing interest High-taxed passive income Rents and royalties from an active trade or business Income from “base differences” (foreign income taxed

that is not included in income under U.S. principles) – tax years beginning after 12/31/2004

INTRODUCTION TO INTERNATIONAL TAXATIONIncome Tax Treaties

PwC

OBJECTIVES OF INCOME TAX TREATIES

Reduce or eliminate double taxation of income earned in one country by a resident of another country

Avoid excessive rates of taxation Stimulate cross-border investment via tax

reduction and certainty of treatment Promote cooperation among countries in

enforcing and administering tax laws Prevent the tax laws of one country from

discriminating against residents of another country

MITIGATING DOUBLE TAXATION

Cross-border investment or transactions may give rise to an income tax exposure in two or more taxing jurisdictions Taxpayer’s country of residence (home country) Country where income is earned (source country)

Cumulative taxation by both the home and source country is disruptive to cross-border trade and countries attempt to solve double taxation problems with either an exemption system or a foreign tax credit system

These unilateral local-country statutory measures do not always provide adequate relief from double taxation

CATEGORIES OF INCOME ADDRESSED BY TREATIES

Income taxed in source country Business profits attributable to a permanent

establishment Real property income

Income subject to limited taxation in source country Passive income (dividends, interest, rents, royalties) Income earned by teachers, trainees, artists, athletes,

etc. Income subject to tax in home country only

Gains from the sale of personal property (not connected with PE and not subject to FIRPTA)

TAXES ADDRESSED BY TREATIES – U.S. MODEL, ARTICLE 2

U.S. taxes Federal income taxes Federal excise taxes on private foundations Not federal social security taxes Not state and local taxes

Foreign taxes As specifically listed in each treaty

U.S. INCOME TAX TREATY NETWORK

U.S. has income tax treaties with over 60 countries Most European countries and other major trading

partners (e.g., Mexico, Canada, Japan, China, Australia, former Soviet Union countries)

Many “gaps” in U.S. tax treaty network South America Africa Asia Middle East

CREATION OF INCOME TAX TREATIES

Income tax treaties are bilateral agreements between two countries

Model tax treaties are used as starting points for negotiation

Treaties may be amended with “Protocols” or replaced with new treaties

KEY TREATY QUESTIONS

Does an income tax treaty exist? Has the treaty entered into force (and

not been terminated)? Is the taxpayer eligible for treaty

benefits? How does the treaty apply to a

specific activity or item of income? ?

TREATIES VS. U.S. STATUTORY LAW

Treaties have equal standing with provisions of the U.S. Constitution and with U.S. domestic laws The Constitution’s Supremacy Clause (Article VI, Sec.

2) provides: “This Constitution, and the laws of the United States which shall be made in pursuance thereof, and all treaties made, or which shall be made, under the authority of the United States, shall be the supreme law of the land.”

Whitney v. Robertson, 124 U.S. 190, 194 (1888): Both treaty and statue are declared by the Constitution to be the supreme law of the land, and no superior efficacy is given to either over the other.

TREATIES VS. LAW - SECTION 894(A)

Current The provisions of this title shall be applied to any

taxpayer with due regard to any treaty obligation of the United States which applies to such taxpayer.

Prior to 1988 Amendment Income of any kind, to the extent required by any

treaty obligation of the United States, shall not be included in gross income and shall be exempt from taxation under this subtitle.

TREATIES VS. LAW - SECTION 7852(D)

Current For purposes of determining the relationship between

a provision of a treaty and any law of the United States affecting revenue, neither the treaty nor the law shall have preferential status by reason of its being a treaty or law.

Prior to 1988 Amendment No provision of this title shall apply in any case where

its application would be contrary to any treaty obligation of the United States in effect on the date of enactment of this title.

LAST-IN-TIME RULE

Courts should first try to resolve apparent conflicts by seeking an interpretation that avoids inconsistency

When treaty and law are inconsistent the last one in time will control the other

A treaty may supersede a prior act of Congress, and an act of Congress may supersede a prior treaty

A number of “treaty overrides” have been enacted by Congress Examples include FIRPTA, the branch profits tax,

§163(j) Generally requires clear Congressional intent to

override treaties

MUTUAL AGREEMENT – COMPETENT AUTHORITY (ARTICLE 25)

The mutual agreement article provides for resolution by the tax authorities of disputes and situations not adequately addressed in the treaty Generally not limited by remedies provided by the

domestic law of either country or the time limits prescribed in such laws for presenting claims for refund

Competent authority not required to reach an agreement (but should make a good faith effort)

ORGANIZATION OF A TREATY General Rules

Article 1--General Scope Article 2--Taxes Covered Article 3--General Definitions Article 24--Non-Discrimination Article 28--Entry into Force Article 29--Termination

Eligibility for Treaty Benefits Article 4—Residence Article 22--Limitation on Benefits

Double Tax Relief Article 23--Relief from Double Taxation Article 25--Mutual Agreement Procedure

ORGANIZATION OF A TREATY (CONT’D) Administrative Cooperation

Article 26--Exchange of Information and Administrative Assistance

Ability to Tax Income Article 5--Permanent Establishment Article 6--Income from Real Property (Immovable

Property)

Article 7--Business Profits Article 8--Shipping and Air Transport Article 9--Associated Enterprises Article 10--Dividends Article 11--Interest Article 12--Royalties Article 13--Gains

ORGANIZATION OF A TREATY (CONT’D) Ability to Tax Income (cont’d)

Article 14—Income from Employment Article 15—Directors Fees Article 16—Entertainers and Sportsmen Article 17--Pensions, Social Security, Annuities,

Alimony, and Child Support

Article 18 – Pension Funds Article 19--Government Service Article 20--Students and Trainees Article 21--Other Income Article 27--Diplomatic Agents and Consular Officers

RESIDENCY – ARTICLE 4

Individuals Treated as a resident of the country in which subject to

tax by reason of domicile, residence or citizenship Corporations

Treated as a resident of the country in which subject to tax by reason of place of management, place of incorporation, or similar criteria

Fiscally transparent entities Income of a fiscally transparent entity is treated as

income derived by a resident to extent the income is taxable to a resident

RESIDENCY (CONT’D)

Certain tax-exempt entities Qualified governmental entities A person is not a resident of a country simply

because such person is subject to tax in the country with respect only to: Income derived from sources within the country, or Business profits attributable to a permanent

establishment located in the country

PERMANENT ESTABLISHMENT – ARTICLE 5

Existence of a PE within a country creates income tax exposure within source country

Similar to “carrying on a trade or business” concept in U.S. tax law “Trade or Business” not defined by the Code PE rules provide more certainty and safe harbors

PE DEFINED

A fixed place of business through which the business of an enterprise is wholly or partly carried on a place of management, branch, office, factory, or

workshop a mine, an oil or gas well, a quarry, or any other place

of extraction of natural resources a drilling rig or ship used to explore for natural

resources if the activity lasts longer than 12 months a construction or installation project that lasts longer

than 12 months

PE EXCLUSIONS

A PE does not include: facilities used solely to store, display, or deliver goods

belonging to enterprise maintenance of a stock of goods solely for purpose of

storage, display or delivery, or processing by another enterprise

maintenance of a fixed place of business solely to purchase goods, collect information, or any other activity of a "preparatory or auxiliary" nature

PE ATTRIBUTION THROUGH OTHER ENTITIES

Subsidiary – Article 5(7) Simply owning control of a subsidiary corporation does

not create a PE for parent corporation in the subsidiary country

The activities of a subsidiary could create a PE for parent if the subsidiary is considered a dependent agent and habitually exercises an authority to conclude contracts in the parent’s name (Taisei Fire and Marine Co. Ltd. 104 T.C. No. 27 (1995); OECD Commentary, Article 5(41))

Partnership The PE of a partnership is imputed to the partners

(Rev. Rul. 90-80; Unger, 936 F2d 1316, DC Cir., 1991)

PE ATTRIBUTION THROUGH AGENTS

Independent agents Doing business through an independent agent does

not create a PE, provided the agent is acting in the ordinary course of its business as an independent agent

Dependent agents Dependent agent can create a PE if the agent

habitually exercises an authority to conclude contracts that are binding on taxpayer

BUSINESS PROFITS – ARTICLE 7

Business profits are those profits the PE would earn “if it were a distinct and independent enterprise engaged in the same or similar activities” Includes only income “derived from the assets or

activities of the permanent establishment” Deductions allowed for direct PE expenses and a

reasonable allocation of indirect expenses Generally narrower definition than the “force of

attraction” rule under §864(c)(3) for foreign persons engaged in a U.S. trade or business

U.S. MODEL TREATY OTHER SPECIFIC ARTICLES

Dividends - General Rule: 15%; Rate reduced to 5% if recipient has a substantial ownership interest (generally 10% or 25%); certain newer treaties (e.g., Japan, Australia, UK and Mexico) provide for no withholding in certain circumstances

Interest - U.S. Model grants the exclusive right to tax interest to the recipient’s country of residence. However can see interest W/H between 5 – 17.5%

Royalties - U.S. model grants the exclusive right to tax royalties to the recipient's country of residence. However can see royalty W/H between 5 - 10%

Capital Gains on sale of personal property - Many U.S. treaties grant the exclusive rights to tax capital gains to the county in which the seller is resident. However FIRPTA provisions override this general rule

ROLE OF TREATIES IN INTERNATIONAL TAX PLANNING

Tax treaties are an important tool in tax planning Inbound Outbound Foreign-to-foreign

Provide greater level of certainty as to tax exposure

Reduce withholding taxes Provide mechanisms for resolving tax disputes

INTRODUCTION TO INTERNATIONAL TAXATION

Planning Concepts

PwC

Framework for Planning Opportunities

BEST PRACTICES COMPONENTS OF AN INTEGRATED GLOBAL STRUCTURE

PLANNING OPPORTUNITIES

Migration and deferral Finance and risk management Jurisdictional Legislative

Migration & Deferral Strategies

Migration & Deferral Strategies

New PlantsTax-Favored

Locations

Low ProfitFunctional

Service Centers

Commissionaireand Strip-Risk

Marketing

R&DCost-Sharing

Low-TaxedTrading

Companies

Flexible and Effective

Transfer Pricing Policy

ContractManufacturing

APB 23

Tax-FavoredLegal Structure,

IncludingHolding Companies

MIGRATION AND DEFERRAL

Creating Debt Through

Intercompany Asset Sales

Risk Management & Financial Products

Factoring of Receivables

FormalCapital

Reductions

DividendStrips

CaptiveInsurance

Companies

Tax- AdvantagedLeasing

Treasury & Cash

Management

HybridInstruments

OptimizeCross-BorderWithholding

Taxes

Capital Loss/Gain Strategies

ExportIncentive

Enhancement

Finance & Risk Management

Strategies

FINANCE AND RISK MANAGEMENT

Local Incentives,e.g., Research

Credits, Investment Incentives

Export TaxIncentives

Internal Tax FreeAsset Step-Ups

and Revaluations

Local Imputation

System Benefits

Tax Holidaysand Special Tax Zones

Conversion ofOrdinary Income

to Tax RateFavored Income

Monetize Deferred

Tax Assets

Special PurposeVehicles

Tax Structure,Branch,

Subsidiary, etc.

Indirect Tax Reduction

JurisdictionalStrategiesJurisdictional

Strategies

JURISDICTIONAL

Lobbying for Reduction in Cross-Border

Withholding Taxes

PromotingFavorable

Tax Treaties

MaintainingIncentives

FASB Initiatives

(APB 23, etc.)

WTO Initiatives

Negotiate Indirect Tax Rates and

Credits

LegislativeStrategies

Protecting TaxFavored Treatmentof Income Sources

and Taxation

LEGISLATIVE

KEY PLANNING IDEAS Take advantage of US and foreign tax incentives Deferral of US tax on foreign source income

Cash tax and financial statement tax expense (ASC 740 - FAS 109 & APB 23)

Maximize use of foreign tax credits Manage FTC limit Reduce foreign income taxes & withholding taxes

Manage profit portability potential of global profits Optimum placement of intangible property Optimum use of debt financing, technology

charges, management fees Use of entities and structures that allow optimum

placement of profits and losses (e.g., use of buy/sell distributors, commissionaires, and contract manufacturers)

PROFIT PORTABILITY POTENTIAL

Ability to Align or Realign Profits in Taxing Jurisdictions to Optimize Tax Rates Around the World

PROFIT PORTABILITY POTENTIAL

Break profits into components by business process

Analyze business risks and the related profits Migrate profits to lower-tax jurisdictions Consider migration opportunities Consider tax risk tolerance

Documents

I NTRODUCTION TO I NTERNATIONAL T AXATION US International Tax Framework and Structuring Foreign Operations PwC