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
Foreign Source Income
Taxable Income
US Income Tax
$1,000
600
$1,600
x .35
$ 560
Foreign Source Income
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 Tax Return Foreign Country Tax Return
US Source Income
Foreign Source Income
Deduction for Foreign Tax
Taxable Income
US Income Tax
$1,000
600
-180
$1,420
x .35
$ 497
Foreign Source Income
Taxable Income
Foreign Income Tax
$600
$600
x .30
$180
US TaxForeign TaxWorldwide Tax
Worldwide ETR
$497 180$677
42.30% [$677/$1,600]
US TAXATION – WITH FTC
US Tax Return Foreign Country Tax Return
US Source Income
Foreign 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
Foreign Source Income
Taxable Income
Foreign Income Tax
$600
$600
x .30
$180
US TaxForeign TaxWorldwide Tax
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]
REQUIREMENTS OF A CREDITABLE TAX (CONT’D)
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
REQUIREMENTS OF A CREDITABLE TAX (CONT’D)
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