Chapter 25 Flashcards
Overview of International Taxation (slide 1 of 3)
- The U.S. taxes U.S. taxpayers on “worldwide” income
- The U.S. allows a Foreign Tax Credit (FTC) to be claimed against the U.S. tax to reduce double-taxation (U.S. and foreign) of the same income
Overview of International Taxation (slide 2 of 3)
• Tax reform provisions adopted in 2017 were designed to accomplish several goals
– Likely to increase competitiveness of U.S. businesses that operate in multiple countries
• The most significant objectives include
– Move toward a territorial system of taxation for U.S. businesses
– Provide incentives for U.S. businesses to locate jobs in the U.S. and repatriate foreign profits back to the U.S.
– Prevent U.S. entities from shifting taxable income into low-tax-rate countries
Overview of International Taxation (slide 3 of 3)
• For foreign taxpayers, the U.S. generally taxes only income earned within its borders
• The U.S. taxation of cross-border transactions can be organized in terms of:
– Outbound taxation
• Refers to the U.S. taxation of foreign-source income earned by U.S. taxpayers
– Inbound taxation
• Refers to the U.S. taxation of U.S.-source income earned by foreign taxpayers
International Tax Treaties(slide 1 of 3)
• Tax treaties exist between the U.S. and many other countries
– Provisions generally override the treatment called for under the Internal Revenue Code or foreign tax statutes
– Generally provide taxing rights for the taxable income of residents of one treaty country who have income sourced in the other treaty country
International Tax Treaties (slide 2 of 3)
• Tax treaties generally:
– Give one country primary taxing rights
– Require the other country to allow a credit for the taxes paid on the twice-taxed income
• Which country receives primary taxing rights usually depends on
– The residence of the taxpayer, or
– The presence of a permanent establishment
• Generally, a permanent establishment is a branch, office, factory, workshop, warehouse, or other fixed place of business.
International Tax Treaties (slide 3 of 3)
• Most U.S. income tax treaties reduce withholding on certain items of investment income
– For example, the treaty with Ireland reduces withholding on dividends to 15% and on interest to zero
– Many new treaties (e.g., with Japan and Australia) provide for a zero rate of withholding on dividend payments to foreign parent corporations
• The U.S. has developed a Model Income Tax Convention as the starting point for negotiating income tax treaties with other countries
Sourcing of Income and Deductions
• The sourcing of income and deductions inside and outside the U.S. is important to both U.S. and foreign taxpayers:
– For example, foreign taxpayers generally are taxed only on income sourced inside the U.S., and
– For example, U.S. taxpayers receive relief from double taxation under the FTC rules based on their foreign-source income
• As a result, an examination of sourcing rules is often the starting point in addressing international tax issues
Sourcing of Income (slide 1 of 9)
Interest Income
– Interest income from the U.S. government, the District of Columbia, from U.S. corporation and from noncorporate U.S. residents is treated as U.S. source income
– Exceptions
• Certain interest received from a U.S. corporation that earned 80% or more of its active business income from foreign sources over the prior 3 year period is treated as foreign-source income
• Interest received on amounts deposited with a foreign branch of a U.S. corporation is treated as foreign-source income if the branch is engaged in the commercial banking business
Sourcing of Income (slide 2 of 9)
•Dividend Income
– Dividends received from domestic corporations are sourced inside the U.S.
– Generally, dividends paid by a foreign corporation are foreign-source income
• Exception: If 25% or more of foreign corporation’s gross 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
Sourcing of Income(slide 3 of 9)
•Personal Services Income
–Sourced where the services are performed
–A limited commercial traveler exception to avoid being classified as U.S.-source income applies to non-resident aliens in the U.S. 90 days or less during the tax year if
• U.S. compensation does not exceed $3,000.
• The services are performed on behalf of:
– A non-U.S. enterprise not engaged in a U.S. trade or business, or
– An office or place of business maintained in a country outside the U.S. by an individual who is a citizen or resident of the U.S., a domestic partnership, or a domestic corporation
Sourcing of Income (slide 4 of 9)
•Rents and Royalties
– Income received for tangible property (rents) is sourced in country in which rental property is located
– Income received for intangible property is sourced in the country in which the property is used
• For example, patents, copyrights, and secret processes and formulas
Sourcing of Income (slide 5 of 9)
•Sale or Exchange of Property
– Generally, the location of real property determines the source of any income derived from the property
– Income from sale of personal property depends on several factors, including:
• Whether the property was produced by the seller
• The type of property sold (e.g., inventory or a capital asset)
• The residence of the seller
Sourcing of Income (slide 6 of 9)
•Sale or Exchange of Property (continued)
– Generally, income, gain, or profit from the sale of personal property is sourced according to the residence of the seller
– Income from the sale of purchased inventory is sourced based on where the sale takes place
Sourcing of Income (slide 7 of 9)
- Sale or Exchange of Property (continued)
* When the seller has produced the inventory, the income is sourced to the country in which the assets were produced
Sourcing of Income (slide 8 of 9)
•Sale or Exchange of Property (continued)
• Income from the sale of personal property other than inventory is sourced at the residence of the seller unless:
– Gain on the sale of depreciable personal property
• Sourced according to prior depreciation deductions
– Any excess gain is sourced the same as the sale of inventory
– Gain on the sale of intangibles
• Sourced according to prior amortization
• Contingent payments are sourced as royalty income
Sourcing of Income (slide 9 of 9)
•Sale or Exchange of Property (continued)
– Gain attributable to an office or fixed place of business maintained outside the U.S. by a U.S. resident is foreign-source income
– 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
• Special rules apply to transportation and communication income
Allocation and Apportionment of Deductions (slide 1 of 4)
• Deductions and losses must be allocated and apportioned between U.S.- and foreign-source income
– Deductions directly related to an activity or property are allocated to the activity or property
• Then, deductions are apportioned between statutory and residual groupings
– A deduction not definitely related to any class of gross income is ratably allocated to all classes of gross income
• Then apportioned between U.S.- and foreign-source income
Allocation and Apportionment of Deductions (slide 2 of 4)
• Interest expense
– Allocated and apportioned to all activities and property regardless of the specific purpose for incurring the debt
– Allocation and apportionment is based on the tax book value of assets
• Special rules apply in an affiliated group setting
Allocation and Apportionment of Deductions (slide 3 of 4)
• Special rules apply to: – Research and development expenditures – Certain stewardship expenses – Legal and accounting fees – Income taxes – Losses
Allocation and Apportionment of Deductions (slide 4 of 4)
•§482 gives the IRS the power to reallocate income, deductions, credits or allowances between or among related persons when
– Necessary to prevent the evasion of taxes, or
– To reflect income more clearly
Foreign Currency Transactions(slide 1 of 4)
• May be necessary to translate amounts denominated in foreign currency into U.S. dollars
• Major tax issues related to foreign currency exchange include:
– Character of gain/loss (capital or ordinary)
– Date of recognition of gain/loss
– Source of foreign currency gain/loss
Foreign Currency Transactions(slide 2 of 4)
• Important concepts related to tax treatment of foreign currency exchange transactions include:
– Foreign currency is treated as property other than money
– Gain/loss is considered separately from underlying transaction
– No gain/loss is recognized until a transaction is closed
Foreign Currency Transactions(slide 3 of 4)
•Functional currency approach under ASC 830 is used for tax purposes
– All income tax determinations are made in taxpayer’s functional currency
– Taxpayer’s default functional currency is the U.S. dollar
Foreign Currency Transactions(slide 4 of 4)
• A qualified business unit (QBU) operating in a foreign country uses that country’s currency as its functional currency
– QBU is a separate and clearly identified unit of a taxpayer’s trade or business (e.g., a foreign branch)
– An individual is not a QBU but a trade or business conducted by a taxpayer may be a QBU
Foreign Branch Currency Exchange Treatment
• When foreign branch operations use a foreign currency as functional currency
– Compute profit/loss in foreign currency
– Translate into U.S. dollar using average exchange rate for the year
• Exchange gains/losses are recognized on remittances from the branch
– Gain/loss is ordinary
– Sourced according to income to which the remittance is attributable
Distributions From Foreign Corporations
• Included in income at exchange rate in effect on date of distribution
– No exchange gain/loss is recognized
• Deemed dividend distributions under Subpart F are translated at average exchange rate for tax year
– Exchange gain/loss can arise when an actual distribution of this previously taxed income is made
Foreign Taxes
• For purposes of the foreign tax credit, taxes accrued are translated at the average exchange rate for the tax year
– An exception to this rule requires translation at the rate taxes were actually paid
U.S. Persons With Foreign Income(slide 1 of 2)
• U.S. taxpayers often “internationalize” gradually over time
– A U.S. business may begin exploring foreign markets by exporting its products abroad, then
– Licensing its products to a foreign manufacturer, or
– Entering into a joint venture with a foreign partner
• If entry into foreign markets is successful, the U.S. business may create a foreign subsidiary and move a portion of its operations abroad by establishing a sales or manufacturing facility
Export Property (slide 1 of 2)
• The easiest way for a U.S. enterprise to engage in global commerce is simply to sell U.S.-produced goods and services abroad
• The U.S. tax consequences of simple export sales are straightforward
– All such income is taxed in the United States to the U.S. taxpayer
Export Property (slide 2 of 2)
• Whether foreign taxes must be paid on this export income depends on
– The laws of the particular foreign jurisdiction, and
– Whether the U.S. taxpayer is deemed to have a foreign business presence there
• Often called a “permanent establishment”
• In many cases, such export income is not taxed by a foreign jurisdiction
Foreign Tax Credit(slide 1 of 3)
• Foreign tax credit (FTC) provisions are designed to reduce the possibility of double taxation
– Allows a credit for foreign income taxes paid
• Credit is a dollar-for-dollar reduction of U.S. income tax liability
– The FTC is subject to an overall limitation
• May result in some form of double taxation on income where the U.S. tax rates are lower than those of the countries in which the income is earned
Foreign Tax Credit (slide 3 of 3)
• A separate FTC is computed for each of four types of taxable income (“baskets”)
– The FTC baskets include the following types of income
• Active, business income
• Portfolio income, like dividends and capital gains
• Income from foreign branches
• Certain intangible income (discussed later)
Cross-Border Asset Transfers
• As part of “going international,” a U.S. taxpayer may decide to transfer assets outside the U.S
• Tax consequences of transferring assets to a foreign corporation depend on
– The nature of the exchange
– The assets involved
– Income potential of the property
– Character of the property in the hands of the transferor or transferee
Outbound Transfers(slide 1 of 2)
• 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.
– Starting a new corp outside the U.S.
– Liquidating a U.S. subsidiary into an existing non-U.S. subsidiary
– Others
Outbound Transfers (slide 2 of 2)
• Transfer of trade or business property generally qualifies for deferral of gain or loss
– Transfer of “tainted” assets triggers immediate recognition of gain but not loss
– In addition, U.S. depreciation and other recapture potential must be recognized to the extent of gain realized
Inbound and Offshore Transfers
• U.S. persons involved in an inbound or offshore transfer involving stock of a controlled foreign corporation (CFC)
– Generally, recognize dividend income to the extent of their pro rata share of previously untaxed E & P of the foreign corporation, or
– Enter into a gain recognition agreement with the IRS that may allow income to be deferred
Tax Havens
• A tax haven is a country where either locally-sourced income, or residents of the country, are subject to no or low host-country taxation
– A tax haven can be created by an income tax treaty
– Investing through a corporation created in a treaty country, when the majority of its shareholders are not residents of such treaty country, is known as “treaty shopping”
Controlled Foreign Corporations (slide 1 of 4)
• To minimize current tax liability, taxpayers often attempt to defer the recognition of taxable income
– One way to do this is to shift the income-generating activity to a foreign entity that is not within the U.S. tax jurisdiction
• A foreign corporation is the most suitable entity for such an endeavor
• Because of the potential for abuse, Congress has enacted various provisions to limit the availability of deferral
Controlled Foreign Corporations (slide 2 of 4)
• 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:
– Pro rata share of Subpart F income
– Increase in earnings that the CFC has invested in U.S. property
Controlled Foreign Corporations (slide 3 of 4)
•Subpart F Income includes the following
–Insurance income (§ 953)
–Foreign base company income (§ 954)
–Illegal bribes
•U.S. shareholders include in gross income their pro rata share of the CFC’s increase in investment in U.S. property for the taxable year
–Property generally includes
• U.S. real property,
• Debt obligations of U.S. persons, and
• Stock in certain related domestic corporations
–The CFC must have sufficient E & P to support a deemed dividend
Controlled Foreign Corporations (slide 4 of 4)
• A CFC is any foreign corporation in which more than 50% of total voting power or value is owned by U.S. shareholders on any day of tax year
– U.S. shareholder is a U.S. person who owns (directly or indirectly) 10% or more of voting stock of the foreign corp
Movement Toward a Territorial System (slide 1 of 4)
• Effective in 2018, C corps. are allowed a limited version of territorial taxation, while also being encouraged to repatriate any profits accumulated from past tax years
– A dividend received deduction (DRD) of 100% is allowed for amounts paid to a U.S.-parent C corp. from E & P of a non-U.S., “10%-owned” subsidiary
• This rule exempts from U.S. taxation the foreign-source profits that underlie the dividend payment (thereby resembling a territorial taxing system), and
• It encourages the return of cash accumulations to the U.S. economy
Movement Toward a Territorial System (slide 2 of 4)
•The DRD is allowed even if the foreign affiliate is not a CFC of the U.S. parent
–Subpart F pass-through constructive dividends do not qualify for the DRD
–To qualify for the DRD, the U.S. parent must have owned the stock of the offshore affiliate for at least one year
•In addition, any recognized gain on the sale or disposition of stock of a 10%-owned CFC by a U.S. shareholder is treated as dividend income and triggers the DRD, to the extent of the transferor’s share of unrepatriated, untaxed E & P of the corporation
Movement Toward a Territorial System (slide 3 of 4)
•One-Time 2017 Transition Tax
– Included in the 2017 Subpart F income of C corps. with unrepatriated E & P was the U.S. parent’s share of the untaxed, unrepatriated post-1986 E & P of its 10%-owned foreign subsidiaries, measured typically as of the end of 2017
– This E & P was subjected to a tax rate of 15.5% (8% if the E & P was distributed in a form other than cash)
• The tax was payable immediately, or by election the payment could be spread out over eight years
• No foreign tax credit was allowed against the one-time tax liability
