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Chapter 9 presentation

  1. 1. Chapter 9 Taxation of International Transactions
  2. 2. The Big Picture (slide 1 of 3) <ul><li>VoiceCo, a domestic corporation, designs, manufactures, and sells specialty microphones for use in theaters. </li></ul><ul><li>All of its activities take place in Florida </li></ul><ul><ul><li>But, it ships products to customers all over the United States. </li></ul></ul><ul><li>When it receives some inquiries about its products from foreign customers, VoiceCo decides to test the foreign market and places ads in foreign trade journals. </li></ul><ul><ul><li>Soon it is taking orders from foreign customers. </li></ul></ul>
  3. 3. The Big Picture (slide 2 of 3) <ul><li>VoiceCo is concerned about its potential foreign income tax exposure. </li></ul><ul><li>Although it has no assets or employees in the foreign jurisdictions, it now is involved in international commerce and has many questions. </li></ul><ul><ul><li>Is VoiceCo subject to income taxes in foreign countries? </li></ul></ul><ul><ul><li>Must it pay U.S. income taxes on the profits from its foreign sales? </li></ul></ul><ul><ul><li>What if VoiceCo pays taxes to other countries? </li></ul></ul><ul><ul><ul><li>Does it receive any benefit from these payments on its U.S. tax return? </li></ul></ul></ul>
  4. 4. The Big Picture (slide 3 of 3) <ul><li>Suppose that VoiceCo establishes a manufacturing plant in Ireland. </li></ul><ul><ul><li>VoiceCo incorporates the Irish operation as VoiceCo-Ireland, a foreign corporation. </li></ul></ul><ul><ul><li>Ireland imposes only a 12.5% tax on VoiceCo-Ireland’s profits. </li></ul></ul><ul><li>So long as VoiceCo-Ireland does not distribute profits to VoiceCo, will the profits escape U.S. taxation? </li></ul><ul><li>What are the consequences to VoiceCo of being the owner of a so-called controlled foreign corporation? </li></ul><ul><li>Does it have any reporting requirements with the IRS? </li></ul><ul><li>Read the chapter and formulate your response. </li></ul>
  5. 5. Overview of International Taxation (slide 1 of 2) <ul><li>The U.S. taxes U.S. taxpayers on “worldwide” income </li></ul><ul><li>The U.S. allows a Foreign Tax Credit to be claimed against the U.S. tax to reduce double-taxation (U.S. and foreign) of the same income </li></ul>
  6. 6. Overview of International Taxation (slide 2 of 2) <ul><li>For foreign taxpayers, the U.S. generally taxes only income earned within its borders </li></ul><ul><li>The U.S. taxation of cross-border transactions can be organized in terms of: </li></ul><ul><ul><li>Outbound taxation </li></ul></ul><ul><ul><ul><li>Refers to the U.S. taxation of foreign-source income earned by U.S. taxpayers </li></ul></ul></ul><ul><ul><li>Inbound taxation </li></ul></ul><ul><ul><ul><li>Refers to the U.S. taxation of U.S.-source income earned by foreign taxpayers </li></ul></ul></ul>
  7. 7. U.S. Taxation of Cross-Border Transactions
  8. 8. The Big Picture – Example 2 Double Taxation <ul><li>Return to the facts of The Big Picture on p. 9-2. </li></ul><ul><li>Assume that VoiceCo operates an unincorporated manufacturing branch in Singapore. </li></ul><ul><li>This branch income is taxed in the U.S. as part of Voice-Co’s worldwide income and also in Singapore. </li></ul><ul><ul><li>Without the foreign tax credit to mitigate this double taxation, VoiceCo would suffer an excessive tax burden and could not compete in a global environment. </li></ul></ul>
  9. 9. The Big Picture – Example 3 Inbound Taxation <ul><li>Return to the facts of The Big Picture on p. 9-2 . </li></ul><ul><li>VoiceCo’s major competitor is a Swiss-based foreign corporation with operations in the United States. </li></ul><ul><li>Although not a U.S. person, the Swiss competitor is taxed in the United States on its U.S.-source business income. </li></ul><ul><li>If the Swiss competitor could operate free of U.S. tax, VoiceCo would face a serious competitive disadvantage. </li></ul>
  10. 10. International Tax Treaties (slide 1 of 3) <ul><li>Tax treaties exist between the U.S. and many other countries </li></ul><ul><ul><li>Provisions generally override the treatment called for under the Internal Revenue Code or foreign tax statutes </li></ul></ul><ul><ul><li>Generally provide taxing rights for the taxable income of residents of one treaty country who have income sourced in the other treaty country </li></ul></ul>
  11. 11. International Tax Treaties (slide 2 of 3) <ul><li>Tax treaties generally: </li></ul><ul><ul><li>Give one country primary taxing rights, and </li></ul></ul><ul><ul><li>Require the other country to allow a credit for the taxes paid on the twice-taxed income </li></ul></ul><ul><li>Which country receives primary taxing rights usually depends on </li></ul><ul><ul><li>The residence of the taxpayer, or </li></ul></ul><ul><ul><li>The presence of a permanent establishment </li></ul></ul><ul><ul><ul><li>Generally, a permanent establishment is a branch, office, factory, workshop, warehouse, or other fixed place of business </li></ul></ul></ul>
  12. 12. International Tax Treaties (slide 3 of 3) <ul><li>Most U.S. income tax treaties reduce withholding on certain items of investment income </li></ul><ul><ul><li>e.g., Treaties with France and Sweden reduce withholding on dividends to 15% and on certain interest to zero </li></ul></ul><ul><ul><li>Many new treaties (e.g., with the United Kingdom and Australia) provide for no withholding on dividend payments to parent corporations </li></ul></ul><ul><li>The U.S. has developed a Model Income Tax Convention as the starting point for negotiating income tax treaties with other countries </li></ul>
  13. 13. Sourcing of Income (slide 1 of 9) <ul><li>Interest income </li></ul><ul><ul><li>Interest income from the U.S. government, the District of Columbia, from U.S. corp. and from noncorporate U.S. residents is treated as U.S. source income </li></ul></ul><ul><ul><li>Exceptions </li></ul></ul><ul><ul><ul><li>Certain interest received from a U.S. corp. that earned ≥ 80% of its active business income from foreign sources over the prior 3 year period is treated as foreign-source income </li></ul></ul></ul><ul><ul><ul><li>Interest received on amounts deposited with a foreign branch of a U.S. corp. is treated as foreign-source income if the branch is engaged in the commercial banking business </li></ul></ul></ul>
  14. 14. Sourcing of Income (slide 2 of 9) <ul><li>Dividend income </li></ul><ul><ul><li>Dividends received from domestic corps. are sourced inside the U.S. </li></ul></ul><ul><ul><li>Generally, dividends paid by a foreign corp. are foreign-source income </li></ul></ul><ul><ul><ul><li>Exception - If ≥ 25% of foreign corp.’s income is effectively connected with a U.S. trade or business for the 3 tax years immediately preceding dividend payment, that percentage of the dividend is treated as U.S.-source income </li></ul></ul></ul>
  15. 15. Sourcing of Income (slide 3 of 9) <ul><li>Personal services income </li></ul><ul><ul><li>Sourced where the services are performed </li></ul></ul><ul><ul><li>A limited commercial traveler exception applies to non-resident aliens in the U.S. 90 days or less during the tax year </li></ul></ul><ul><ul><ul><li>If U.S. compensation does not exceed $3,000 and the services are performed for a non-U.S. enterprise not engaged in a U.S. trade or business, the income is not U.S. source </li></ul></ul></ul>
  16. 16. Sourcing of Income (slide 4 of 9) <ul><li>Rents and Royalties </li></ul><ul><ul><li>Income received for tangible property (rents) is sourced in country in which rental property is located </li></ul></ul><ul><ul><li>Income received for intangible property (royalties) is sourced where property producing the income is used </li></ul></ul>
  17. 17. Sourcing of Income (slide 5 of 9) <ul><li>Sale or exchange of property </li></ul><ul><ul><li>Generally, the location of real property determines the source of any income derived from the property </li></ul></ul><ul><ul><li>Income from sale of personal property depends on several factors, including: </li></ul></ul><ul><ul><ul><li>Whether the property was produced by the seller </li></ul></ul></ul><ul><ul><ul><li>The type of property sold (e.g., inventory or a capital asset) </li></ul></ul></ul><ul><ul><ul><li>The residence of the seller </li></ul></ul></ul>
  18. 18. Sourcing of Income (slide 6 of 9) <ul><li>Sale or exchange of property (cont’d) </li></ul><ul><ul><li>Generally, income, gain, or profit from the sale of personal property is sourced according to the residence of the seller </li></ul></ul><ul><ul><li>Income from the sale of purchased inventory is sourced based on where the sale takes place </li></ul></ul>
  19. 19. Sourcing of Income (slide 7 of 9) <ul><li>Sale or exchange of property (cont’d) </li></ul><ul><ul><li>When the seller has produced the inventory property </li></ul></ul><ul><ul><ul><li>Income must be apportioned between the country of production and the country of sale </li></ul></ul></ul><ul><ul><ul><li>50/50 allocation is used unless taxpayer elects to use the independent factory price or the books and records method </li></ul></ul></ul>
  20. 20. Sourcing of Income (slide 8 of 9) <ul><li>Sale or exchange of property (cont’d) </li></ul><ul><li>Income from the sale of personal property other than inventory is sourced at the residence of the seller unless: </li></ul><ul><ul><li>Gain on the sale of depreciable personal property </li></ul></ul><ul><ul><ul><li>Sourced according to prior depreciation deductions </li></ul></ul></ul><ul><ul><ul><ul><li>Any excess gain is sourced the same as the sale of inventory </li></ul></ul></ul></ul><ul><ul><li>Gain on the sale of intangibles </li></ul></ul><ul><ul><ul><li>Sourced according to prior amortization </li></ul></ul></ul><ul><ul><ul><li>Contingent payments are sourced as royalty income </li></ul></ul></ul>
  21. 21. Sourcing of Income (slide 9 of 9) <ul><li>Sale or exchange of property (cont’d) </li></ul><ul><ul><li>Gain attributable to an office or fixed place of business maintained outside the U.S. by a U.S. resident is foreign-source income </li></ul></ul><ul><ul><li>Income or gain attributable to an office or fixed place of business maintained in the U.S. by a nonresident is U.S.-source income </li></ul></ul><ul><li>Special rules apply to transportation and communication income </li></ul>
  22. 22. Allocation and Apportionment of Deductions (slide 1 of 4) <ul><li>Deductions and losses must be allocated and apportioned between U.S.- and foreign-source income </li></ul><ul><ul><li>Deductions directly related to an activity or property are allocated to classes of income </li></ul></ul><ul><ul><ul><li>Then, deductions are apportioned between statutory and residual groupings </li></ul></ul></ul><ul><ul><li>A deduction not definitely related to any class of gross income is ratably allocated to all classes of gross income </li></ul></ul><ul><ul><ul><li>Then apportioned between U.S.- and foreign-source income </li></ul></ul></ul>
  23. 23. Allocation and Apportionment of Deductions (slide 2 of 4) <ul><li>Interest expense </li></ul><ul><ul><li>Allocated and apportioned to all activities and property regardless of the specific purpose for incurring the debt </li></ul></ul><ul><ul><li>Allocation and apportionment is based on either FMV or tax book value of assets </li></ul></ul><ul><ul><ul><li>Special rules apply in an affiliated group setting </li></ul></ul></ul>
  24. 24. Allocation and Apportionment of Deductions (slide 3 of 4) <ul><ul><li>Special rules apply to: </li></ul></ul><ul><ul><ul><li>Research and development expenditures </li></ul></ul></ul><ul><ul><ul><li>Certain stewardship expenses </li></ul></ul></ul><ul><ul><ul><li>Legal and accounting fees </li></ul></ul></ul><ul><ul><ul><li>Income taxes </li></ul></ul></ul><ul><ul><ul><li>Losses </li></ul></ul></ul>
  25. 25. Allocation and Apportionment of Deductions (slide 4 of 4) <ul><li>§482 gives the IRS the power to reallocate income, deductions, credits or allowances between or among related persons when </li></ul><ul><ul><li>Necessary to prevent the evasion of taxes, or </li></ul></ul><ul><ul><li>To reflect income more clearly </li></ul></ul>
  26. 26. The Big Picture – Example 9 Apportionment Of Interest Expense <ul><li>Return to the facts of The Big Picture on p. 9-2. </li></ul><ul><li>Assume that VoiceCo generates U.S.-source and foreign-source gross income for the current year. </li></ul><ul><li>VoiceCo’s assets (tax book value) are as follows. </li></ul><ul><ul><li>Assets generating U.S.-source income $18,000,000 </li></ul></ul><ul><ul><li>Assets generating foreign-source income 5,000,000 </li></ul></ul><ul><ul><li>$23,000,000 </li></ul></ul><ul><li>VoiceCo incurs interest expense of $800,000 for the current year. Using the tax book value method, interest expense is apportioned to foreign-source income as follows. </li></ul><ul><ul><li>$5,000,000 (foreign assets) </li></ul></ul><ul><ul><li>$23,000,000 (total assets) X $800,000 = $173,913 </li></ul></ul>
  27. 27. Transfer Pricing Example (slide 1 of 2)
  28. 28. Transfer Pricing Example (slide 2 of 2)
  29. 29. Foreign Currency Transactions (slide 1 of 4) <ul><li>May be necessary to translate amounts denominated in foreign currency into U.S. dollars </li></ul><ul><li>Major tax issues related to foreign currency exchange include: </li></ul><ul><ul><li>Character of gain/loss (capital or ordinary) </li></ul></ul><ul><ul><li>Date of recognition of gain/loss </li></ul></ul><ul><ul><li>Source of foreign currency gain/loss </li></ul></ul>
  30. 30. Foreign Currency Transactions (slide 2 of 4) <ul><li>Important concepts related to tax treatment of foreign currency exchange transactions include: </li></ul><ul><ul><li>Foreign currency is treated as property other than money </li></ul></ul><ul><ul><li>Gain/loss is considered separately from underlying transaction </li></ul></ul><ul><ul><li>No gain/loss is recognized until a transaction is closed </li></ul></ul>
  31. 31. Foreign Currency Transactions (slide 3 of 4) <ul><li>Functional currency approach under SFAS 52 is used for tax purposes </li></ul><ul><ul><li>All income tax determinations are made in taxpayer’s functional currency </li></ul></ul><ul><ul><li>Taxpayer’s default functional currency is the U.S. dollar </li></ul></ul>
  32. 32. Foreign Currency Transactions (slide 4 of 4) <ul><li>A qualified business unit (QBU) operating in a foreign country uses that country’s currency as its functional currency </li></ul><ul><ul><li>QBU is a separate and clearly identified unit of a taxpayer’s trade or business (e.g., a foreign branch) </li></ul></ul><ul><ul><li>An individual is not a QBU but a trade or business conducted by a taxpayer may be a QBU </li></ul></ul>
  33. 33. Foreign Branch Currency Exchange Treatment (slide 1 of 2) <ul><li>When foreign branch operations use a foreign currency as functional currency </li></ul><ul><ul><li>Compute profit/loss in foreign currency </li></ul></ul><ul><ul><li>Translate into U.S. dollar using average exchange rate for the year </li></ul></ul>
  34. 34. Foreign Branch Currency Exchange Treatment (slide 2 of 2) <ul><li>Exchange gains/losses are recognized on remittances from the branch </li></ul><ul><ul><li>Gain/loss is ordinary </li></ul></ul><ul><ul><li>Sourced according to income to which the remittance is attributable </li></ul></ul>
  35. 35. Distributions From Foreign Corporations <ul><li>Included in income at exchange rate in effect on date of distribution </li></ul><ul><ul><li>No exchange gain/loss is recognized </li></ul></ul><ul><li>Deemed dividend distributions under Subpart F are translated at average exchange rate for tax year </li></ul><ul><ul><li>Exchange gain/loss can arise when an actual distribution of this previously taxed income is made </li></ul></ul>
  36. 36. Foreign Taxes <ul><li>For purposes of the foreign tax credit, taxes accrued are translated at the average exchange rate for the tax year </li></ul><ul><ul><li>An exception to this rule requires translation at the rate taxes were actually paid </li></ul></ul><ul><ul><ul><li>If paid within 2 years of accrual and differ from accrued amount due to exchange rate fluctuations, no redetermination is required </li></ul></ul></ul><ul><ul><ul><li>Otherwise, where taxes paid differ from amount accrued, a redetermination is required </li></ul></ul></ul>
  37. 37. The Big Picture – Example 13 Apportionment Of Interest Expense <ul><li>Return to the facts of The Big Picture on p. 9-2 . </li></ul><ul><li>Assume that VoiceCo operates a foreign branch. </li></ul><ul><li>Foreign taxes attributable to branch income amount to 5,000K (a foreign currency). </li></ul><ul><ul><li>The taxes are paid within two years of being accrued. </li></ul></ul><ul><ul><li>The average foreign exchange rate for the tax year to which the foreign taxes relate is .5K:$1. </li></ul></ul><ul><ul><li>On the date the taxes are paid, the rate is .6K:$1. </li></ul></ul><ul><li>No redetermination is required, and VoiceCo reports foreign taxes of $10,000 for purposes of the foreign tax credit. </li></ul>
  38. 38. Tax Incentives For Exports (slide 1 of 2) <ul><li>Prior tax law contained a special tax incentive for U.S. taxpayers exporting goods </li></ul><ul><ul><li>Allowed U.S. taxpayers to exclude extraterritorial income (ETI) from U.S. taxation </li></ul></ul><ul><li>The American Jobs Creation Act of 2004 repealed the ETI exclusion </li></ul>
  39. 39. Tax Incentives For Exports (slide 2 of 2) <ul><li>The American Jobs Creation Act of 2004 created a new broad-based “domestic production activities deduction” </li></ul><ul><li>The domestic production activities deduction is equal to 9% of the taxpayer’s qualified production activities income subject to several limitations </li></ul><ul><ul><li>Unlike the earlier ETI exclusion, the DPAD does not require exporting or any other activity outside the United States </li></ul></ul>
  40. 40. Cross-Border Asset Transfers <ul><li>Tax consequences of transferring assets to a foreign corporation depend on </li></ul><ul><ul><li>The nature of the exchange </li></ul></ul><ul><ul><li>The assets involved </li></ul></ul><ul><ul><li>Income potential of the property </li></ul></ul><ul><ul><li>Character of the property in the hands of the transferor or transferee </li></ul></ul>
  41. 41. Outbound Transfers (slide 1 of 3) <ul><li>Similar to exchanges of assets for corporate stock of a domestic corporation, realized gain/loss may be deferred on certain outbound capital changes, moving corporate business outside the U.S. </li></ul><ul><ul><li>Starting a new corp outside the U.S. </li></ul></ul><ul><ul><li>Liquidating a U.S. subsidiary into an existing non-U.S. subsidiary </li></ul></ul><ul><ul><li>Others </li></ul></ul>
  42. 42. Outbound Transfers (slide 2 of 3) <ul><li>Transfer of trade or business property generally qualifies for deferral of gain or loss </li></ul><ul><ul><li>Transfer of “tainted” assets triggers immediate recognition of gain but not loss </li></ul></ul><ul><ul><li>In addition, depreciation and other recapture potential must be recognized to the extent of gain realized </li></ul></ul>
  43. 43. Outbound Transfers (slide 3 of 3) <ul><li>“ Tainted” assets include: </li></ul><ul><ul><li>Inventory </li></ul></ul><ul><ul><li>Installment obligations and unrealized accounts receivable </li></ul></ul><ul><ul><li>Foreign currency </li></ul></ul><ul><ul><li>Property leased by the transferor unless the transferee is the lessee </li></ul></ul>
  44. 44. Cross-border Mergers (slide 1 of 2) <ul><li>The American Jobs Creation Act of 2004 created strict rules to deter owners from turning domestic entities into foreign entities </li></ul><ul><ul><li>A domestic corp. or partnership continues to be treated as domestic if: </li></ul></ul><ul><ul><ul><li>A foreign corp. acquires substantially all of its properties after March 4, 2003 </li></ul></ul></ul><ul><ul><ul><li>The former owners of the U.S. corp. (or partnership) hold ≥ 80% of foreign corp.’s stock after transaction </li></ul></ul></ul><ul><ul><ul><li>The foreign corp. does not have substantial business activities in its country of incorporation </li></ul></ul></ul>
  45. 45. Cross-border Mergers (slide 2 of 2) <ul><li>If former owners own at least 60% but less than 80% of new corp. </li></ul><ul><ul><li>Foreign entity is treated as foreign </li></ul></ul><ul><ul><li>Corporate-level taxes imposed due to the transfer cannot be offset with NOLs, foreign tax credits, or certain other tax attributes </li></ul></ul><ul><li>An excise tax is also imposed on the value of certain stock held by insiders during the 12-month period beginning 6 months before the date of inversion </li></ul>
  46. 46. Inbound and Offshore Transfers <ul><li>U.S. persons involved in an inbound or offshore transfer involving stock of a controlled foreign corporation (CFC) </li></ul><ul><ul><li>Generally, recognize dividend income to the extent of their pro rata share of previously untaxed E & P of the foreign corporation, or </li></ul></ul><ul><ul><li>Enter into a gain recognition agreement with the IRS that may allow income to be deferred </li></ul></ul>
  47. 47. Controlled Foreign Corporations (slide 1 of 3) <ul><li>Certain types of income generated by a controlled foreign corporation (CFC) are currently included in income by U.S. shareholders without regard to actual distributions including: </li></ul><ul><ul><li>Pro rata share of Subpart F income </li></ul></ul><ul><ul><li>Increase in earnings that the CFC has invested in U.S. property </li></ul></ul>
  48. 48. Controlled Foreign Corporations (slide 2 of 3) <ul><li>Subpart F Income includes the following </li></ul><ul><ul><li>Insurance income (§ 953) </li></ul></ul><ul><ul><li>Foreign base company income (§ 954) </li></ul></ul><ul><ul><li>International boycott factor income (§ 999) </li></ul></ul><ul><ul><li>Illegal bribes </li></ul></ul><ul><ul><li>Income derived from a § 901(j) foreign country </li></ul></ul>
  49. 49. Controlled Foreign Corporations (slide 3 of 3) <ul><li>To apply, foreign corp must have been a CFC for an uninterrupted period of 30 days or more during tax year </li></ul><ul><ul><li>A CFC is any foreign corp in which > 50% of total voting power or value is owned by U.S. shareholders on any day of tax year </li></ul></ul><ul><ul><li>U.S. shareholder is a U.S. person who owns (directly or indirectly) 10% or more of voting stock of the foreign corp </li></ul></ul>
  50. 50. U.S. Shareholder’s Income from CFC
  51. 51. Foreign Tax Credit <ul><li>Foreign tax credit (FTC) provisions are designed to reduce the possibility of double taxation </li></ul><ul><ul><li>Allows a credit for foreign income taxes paid </li></ul></ul><ul><ul><ul><li>Credit is a dollar-for-dollar reduction of U.S. income tax liability </li></ul></ul></ul><ul><ul><li>FTC may be “direct” or “indirect” </li></ul></ul><ul><li>The FTC is elective </li></ul><ul><ul><li>May take a deduction for foreign taxes paid or incurred rather than the FTC </li></ul></ul>
  52. 52. Direct Foreign Tax Credit <ul><li>Available to taxpayers who pay or incur a foreign income tax </li></ul><ul><ul><li>Only person who bears the legal burden of the foreign tax is eligible for the direct credit </li></ul></ul><ul><li>Direct credit is not available to a U.S. corporation operating in a foreign country through a foreign subsidiary </li></ul>
  53. 53. Indirect Foreign Tax Credit (slide 1 of 5) <ul><li>The indirect credit is available to U.S. corporations for dividends received (actual or constructive) from foreign corporations </li></ul><ul><ul><li>Foreign corp pays tax in foreign jurisdiction </li></ul></ul><ul><ul><li>When foreign corp remits dividends to U.S. corp, the income is subject to tax in the U.S. </li></ul></ul>
  54. 54. Indirect Foreign Tax Credit (slide 2 of 5) <ul><li>Foreign taxes are deemed paid by U.S. corporate shareholders in same proportion as dividends bear to foreign corp’s post-1986 undistributed E & P </li></ul><ul><ul><li>Indirect FTC = </li></ul></ul><ul><ul><li>Actual or constructive dividend X Post-1986 foreign taxes </li></ul></ul><ul><ul><li>Post-1986 undistributed E & P </li></ul></ul><ul><li>Corporations choosing the FTC for deemed-paid foreign taxes must gross up dividend income by the amount of deemed-paid taxes </li></ul>
  55. 55. Indirect Foreign Tax Credit (slide 3 of 5) <ul><li>Example </li></ul><ul><ul><li>Wren Inc, a domestic corp, receives a $120,000 dividend from Finch Inc, a foreign corp. Finch paid $500,000 of foreign taxes on post-1986 E & P totaling $1,200,000 (after taxes) </li></ul></ul>
  56. 56. Indirect Foreign Tax Credit (slide 4 of 5) <ul><li>Example (cont’d)— Wren’s deemed-paid foreign taxes for FTC purposes are $50,000 </li></ul><ul><ul><li>Cash dividend from Finch $120,000 </li></ul></ul><ul><ul><li>Deemed-paid foreign taxes </li></ul></ul><ul><ul><li>$500,000 × $ 120,000 50,000 </li></ul></ul><ul><ul><li> $1,200,000 </li></ul></ul><ul><ul><li>Gross income to Wren $170,000 </li></ul></ul><ul><ul><li>Wren must include $50,000 in gross income for the gross up adjustment if FTC is elected </li></ul></ul>
  57. 57. Indirect Foreign Tax Credit (slide 5 of 5) <ul><ul><li>Only available if domestic corp owns 10% or more of voting stock of foreign corp </li></ul></ul><ul><ul><ul><li>Credit is available for 2nd and 3rd tier foreign corps if 10% ownership requirement is met </li></ul></ul></ul><ul><ul><ul><li>Credit is also available for 4th through 6th tier foreign corps if additional requirements are met </li></ul></ul></ul>
  58. 58. Foreign Tax Credit Limitations (slide 1 of 4) <ul><li>Limit is designed to prevent foreign taxes from being credited against U.S. taxes on U.S.-source taxable income </li></ul><ul><ul><li>FTC cannot exceed the lesser of: </li></ul></ul><ul><ul><ul><li>Actual foreign taxes paid or accrued, or </li></ul></ul></ul><ul><ul><ul><li>U.S. taxes (before FTC) on foreign-source taxable income, calculated as follows: </li></ul></ul></ul><ul><ul><ul><li>U.S. tax × Foreign-source taxable income </li></ul></ul></ul><ul><ul><ul><li>before FTC Total taxable income* </li></ul></ul></ul><ul><li>*Taxable income of an individual, estate, or trust is computed without any deduction for personal exemptions. </li></ul>
  59. 59. Foreign Tax Credit Limitations (slide 2 of 4) <ul><li>Limitation can prevent total amount of foreign taxes paid in high-tax jurisdictions from being credited </li></ul><ul><ul><li>Generating additional foreign-source income in low, or no, tax jurisdictions could alleviate this problem </li></ul></ul><ul><ul><li>However, a separate limitation must be calculated for certain categories (baskets) of foreign source income </li></ul></ul>
  60. 60. Foreign Tax Credit Limitations (slide 3 of 4) <ul><li>For tax years beginning after 2006, there are only two baskets: </li></ul><ul><ul><li>Passive income, and </li></ul></ul><ul><ul><li>All other (general) </li></ul></ul><ul><li>Any FTC carryforwards into post-2006 years are assigned to one of these two categories </li></ul>
  61. 61. Foreign Tax Credit Limitations (slide 4 of 4) <ul><li>The limitations can result in unused (noncredited) foreign taxes for the tax year </li></ul><ul><ul><li>Carryback period is 1 year </li></ul></ul><ul><ul><li>Carryforward period is 10 years </li></ul></ul><ul><li>The taxes can be credited in years when the formula limitation for that year exceeds the foreign taxes attributable to the same tax year </li></ul><ul><ul><li>The carryback and carryforward provisions are available only within a specific basket </li></ul></ul>
  62. 62. Foreign Losses (slide 1 of 2) <ul><li>May be able to offset foreign losses against U.S.-source income, reducing U.S. income tax due </li></ul><ul><li>If the foreign country in which loss is generated (sourced) taxes subsequent income from these foreign operations, the FTC could reduce or eliminate any U.S. tax on the income </li></ul><ul><ul><li>To prevent this loss of revenue, overall foreign losses must be recaptured as U.S.-source income for FTC purposes </li></ul></ul>
  63. 63. Foreign Losses (slide 2 of 2) <ul><li>Foreign losses are recaptured by reducing the numerator of the FTC limitation formula by the lesser of: </li></ul><ul><ul><li>The remaining unrecaptured overall foreign loss, or </li></ul></ul><ul><ul><li>50% of foreign-source taxable income for the year </li></ul></ul><ul><li>Unrecaptured losses are carried over indefinitely until recaptured </li></ul>
  64. 64. Alternative Minimum Tax FTC <ul><li>For purposes of the alternative minimum tax (AMT), the FTC limitation is calculated as follows: </li></ul><ul><li>AMT FTC limitation = </li></ul><ul><li>Foreign-source AMTI × Tentative Minimum </li></ul><ul><li> Total AMTI Tax </li></ul><ul><li>Taxpayer may elect to use foreign-source regular taxable income in the numerator if it does not exceed total AMTI </li></ul>
  65. 65. U.S. Taxation of Nonresident Aliens and Foreign Corporations <ul><li>Generally, nonresident alien individuals (NRAs) and foreign corps. are subject to U.S. taxation </li></ul><ul><ul><li>On U.S.-source income and </li></ul></ul><ul><ul><li>Foreign-source income when that income is effectively connected with the conduct of a U.S. trade or business </li></ul></ul>
  66. 66. Nonresident Alien Individuals <ul><li>Nonresident alien (NRA)—an individual who is not a citizen or resident of the U.S. </li></ul><ul><ul><li>Citizenship is determined under the immigration and naturalization laws of the U.S. </li></ul></ul><ul><ul><ul><li>The citizenship statutes are broken down into two categories: </li></ul></ul></ul><ul><ul><ul><ul><li>Nationality at birth or </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Through naturalization </li></ul></ul></ul></ul>
  67. 67. Residency Tests for Non Citizens (slide 1 of 3) <ul><li>Green Card Test: </li></ul><ul><ul><li>An individual is considered a resident of the U.S. on the first day of the tax year in which he or she is physically present in the U.S. after the card is issued </li></ul></ul><ul><ul><li>Residency status remains in effect until the card is revoked or the individual has abandoned permanent resident status </li></ul></ul>
  68. 68. Residency Tests for Non Citizens (slide 2 of 3) <ul><li>Substantial Presence Test: </li></ul><ul><ul><li>This mathematical test applies to people in the U.S. without a green card </li></ul></ul><ul><ul><ul><li>An individual in the U.S. 183 days during the year is a resident for the year for tax purposes </li></ul></ul></ul><ul><ul><ul><li>Also a taxpayer in the U.S. for 183 days in the past three years (using a specified weighting formula) is taxed as a resident </li></ul></ul></ul>
  69. 69. Residency Tests for Non Citizens (slide 3 of 3) <ul><ul><li>Exceptions apply to the substantial presence test for </li></ul></ul><ul><ul><ul><li>Commuters from Mexico and Canada who work in the U.S. </li></ul></ul></ul><ul><ul><ul><li>Foreign government-related individuals (e.g., diplomats) </li></ul></ul></ul><ul><ul><ul><li>Qualified teachers </li></ul></ul></ul><ul><ul><ul><li>Trainees and students, and </li></ul></ul></ul><ul><ul><ul><li>Certain professional athletes </li></ul></ul></ul>
  70. 70. U.S. Taxation of Nonresident Aliens (slide 1 of 3) <ul><li>Non-resident alien income not “effectively connected” with U.S. trade or business </li></ul><ul><ul><li>Includes dividends, interest, rents, royalties, certain compensation, premiums, annuities, and other fixed, determinable, annual or periodic (FDAP) income </li></ul></ul><ul><ul><li>30% tax generally is withheld by payors of the income </li></ul></ul><ul><ul><ul><li>Eliminates problems of assuring payment by nonresidents, determining allowable deductions, and, in most instances, the filing of tax returns by nonresidents </li></ul></ul></ul>
  71. 71. U.S. Taxation of Nonresident Aliens (slide 2 of 3) <ul><li>Capital gains not effectively connected with the conduct of a U.S. trade or business are exempt from tax, as long as the NRA individual was not present in the United States for 183 days or more during the taxable year </li></ul>
  72. 72. U.S. Taxation of Nonresident Aliens (slide 3 of 3) <ul><li>Non-resident alien income effectively connected with U.S. trade or business </li></ul><ul><ul><li>This income is taxed at the same rates applicable to U.S. citizens </li></ul></ul><ul><ul><li>Deductions related to the business may be claimed </li></ul></ul>
  73. 73. U.S. Taxation of Foreign Corps (slide 1 of 4) <ul><li>Income not effectively connected with U.S. trade or business </li></ul><ul><ul><li>Taxed at 30% as described above for individuals </li></ul></ul><ul><ul><li>The payor must withhold and remit the tax </li></ul></ul><ul><li>U.S.-source capital gains - exempt from Federal income tax if not effectively connected with conduct of U.S. trade or business </li></ul>
  74. 74. U.S. Taxation of Foreign Corps (slide 2 of 4) <ul><li>Income effectively connected with U.S. trade or business </li></ul><ul><ul><li>This income is taxed at the same rates applicable to U.S. corporations </li></ul></ul><ul><ul><li>Deductions can offset the income </li></ul></ul>
  75. 75. U.S. Taxation of Foreign Corps (slide 3 of 4) <ul><li>Branch profits tax </li></ul><ul><ul><li>If a foreign corporation operates through a U.S. subsidiary (a domestic corp.) </li></ul></ul><ul><ul><ul><li>The income of the subsidiary is taxable by the U.S. when earned </li></ul></ul></ul><ul><ul><ul><li>Also subject to a withholding tax when repatriated (returned as dividends to the foreign parent) </li></ul></ul></ul>
  76. 76. U.S. Taxation of Foreign Corps (slide 4 of 4) <ul><li>Branch profits tax (cont’d) </li></ul><ul><ul><li>In addition to the income tax imposed under § 882 on effectively connected income of a foreign corp., a tax equal to 30% of the dividend equivalent amount (DEA) is imposed </li></ul></ul><ul><ul><ul><li>DEA is the foreign corp’s effectively connected earnings, adjusted for increases and decreases in the corp’s U.S. net equity (investment in U.S. operations) </li></ul></ul></ul><ul><ul><li>The DEA is limited to current E & P and post-1986 accumulated E & P effectively connected, or treated as effectively connected, with the conduct of a U.S. trade or business </li></ul></ul>
  77. 77. Foreign Investment in Real Property Tax Act (slide 1 of 4) <ul><li>Gains and losses realized by NRAs and foreign corps on U.S. real property interests (USRPI) </li></ul><ul><ul><li>Treated as effectively connected with the conduct of a U.S. trade or business </li></ul></ul><ul><li>NRAs must pay tax equal to at least the lesser of </li></ul><ul><ul><li>26% (or 28%) of AMTI, or </li></ul></ul><ul><ul><li>Regular U.S. rates on net real property gain for the year </li></ul></ul>
  78. 78. Foreign Investment in Real Property Tax Act (slide 2 of 4) <ul><li>USRPI is any direct interest in real property situated in U.S. and any interest in a domestic corp </li></ul><ul><ul><li>Applies unless taxpayer can establish that domestic corp was not a U.S. real property holding corp (USRPHC) during the shorter of: </li></ul></ul><ul><ul><ul><li>Period taxpayer owned interest in corp, or </li></ul></ul></ul><ul><ul><ul><li>For 5 year period ending on date interest was disposed of </li></ul></ul></ul>
  79. 79. Foreign Investment in Real Property Tax Act (slide 3 of 4) <ul><li>USRPHC is any corp (foreign or domestic) where FMV of corp’s USRPI is 50% or more of aggregate FMV of: </li></ul><ul><ul><li>USRPIs </li></ul></ul><ul><ul><li>Interests in real property located outside U.S. </li></ul></ul><ul><ul><li>Any other assets used in a trade or business </li></ul></ul><ul><ul><ul><li>Stock regularly traded on established securities market is not a USRPI if 5% or less is owned </li></ul></ul></ul>
  80. 80. Foreign Investment in Real Property Tax Act (slide 4 of 4) <ul><li>Withholding provisions </li></ul><ul><ul><li>Any purchaser or agent acquiring a USRPI from a foreign person must withhold 10% of amount realized on disposition </li></ul></ul><ul><ul><li>Higher withholding rates apply to certain entities </li></ul></ul>
  81. 81. Expatriation to Avoid U.S. Taxation (slide 1 of 2) <ul><li>U.S. tax applies to U.S.-sourced income of persons who relinquished their U.S. citizenship within 10 years of deriving that income </li></ul><ul><ul><li>Only applies if person gave up citizenship to avoid U.S. tax </li></ul></ul>
  82. 82. Expatriation to Avoid U.S. Taxation (slide 2 of 2) <ul><li>Also applies to NRAs who lost U.S. citizenship within preceding 10 year period if principal purpose was avoidance of U.S. tax </li></ul><ul><li>Tax avoidance purpose is presumed if either: </li></ul><ul><ul><li>Average annual net income tax for five preceding taxable years > $147,000 (in 2011) </li></ul></ul><ul><ul><li>Net worth as of that date is $2 million or more </li></ul></ul>
  83. 83. Refocus On The Big Picture (slide 1 of 4) <ul><li>Now you can address the questions about VoiceCo’s activities that were posed at the beginning of the chapter. </li></ul><ul><li>Simply selling into a foreign jurisdiction may not trigger any overseas income tax consequences </li></ul><ul><ul><li>But, such income is taxed currently to VoiceCo in the United States. </li></ul></ul>
  84. 84. Refocus On The Big Picture (slide 2 of 4) <ul><li>When VoiceCo sets up an Irish corporation, it benefits from deferral because as a manufacturer it can avoid deemed dividends under Subpart F. </li></ul><ul><ul><li>However, there may be passive-basket income earned by the Irish subsidiary. </li></ul></ul><ul><ul><li>VoiceCo must file Form 5471 to report on the activities of its foreign subsidiary. </li></ul></ul><ul><ul><li>If VoiceCo receives dividends from its foreign subsidiary, it can claim § 902 foreign tax credits (so-called indirect credits). </li></ul></ul><ul><li>What are the foreign tax implications if VoiceCo ‘‘checks the box’’ on its foreign subsidiary? </li></ul><ul><ul><li>The U.S. tax implications? </li></ul></ul>
  85. 85. Refocus On The Big Picture (slide 3 of 4) <ul><li>What If? </li></ul><ul><li>Suppose VoiceCo decides not to create a foreign subsidiary. </li></ul><ul><li>Instead, VoiceCo decides to license its design and manufacturing process to a local European musical instruments company for sales in Europe. </li></ul><ul><ul><li>The European company pays VoiceCo a royalty equal to 25% of the sales price on all its sales of microphones based on VoiceCo’s design. </li></ul></ul><ul><ul><li>The royalty income is foreign-source income (as the underlying intangible property is exploited outside the United States). </li></ul></ul>
  86. 86. Refocus On The Big Picture (slide 4 of 4) <ul><li>What If? </li></ul><ul><li>The European country imposes a 5% withholding tax on all royalty payments to VoiceCo. </li></ul><ul><ul><li>The royalties are part of its worldwide income and so are currently taxed to VoiceCo in the United States. </li></ul></ul><ul><ul><li>Will VoiceCo receive a foreign tax credit for the withholding tax? </li></ul></ul>
  87. 87. <ul><li>If you have any comments or suggestions concerning this PowerPoint Presentation for South-Western Federal Taxation, please contact: </li></ul><ul><li>Dr. Donald R. Trippeer, CPA </li></ul><ul><li>[email_address] </li></ul><ul><li>SUNY Oneonta </li></ul>

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