R3.4 – Multijurisdictional Tax Issues in Federal Taxation

Question 1

Taxation of Foreign Income

Answer 1

Treaties between the US and other countries generally override US tax law or foreign tax law provisions

Foreign taxpayers taxed only on US income

US taxpayers taxed on all income earned anywhere in the world

Question 2

Taxation of Foreign Income of US Taxpayers

Answer 2

US taxpayers taxed on all income earned anywhere in the world

Three provisions mitigate potential taxation of foreign income of US taxpayers

1. Foreign income taxes paid = itemized deduction for individuals
2. Credit for foreign taxes paid
3. Exclusion of some foreign-earned income

Question 3

Credit for Foreign Taxes Paid

Answer 3

Credit for foreign taxes limited if US effective rate > foreign effective rate

Limit
= US tax on global income
× foreign-source taxable income
÷ worldwide taxable income

Individuals add personal exemption to worldwide income

Excess foreign tax: 1 yr carry back and 10 yr carry forward

$97,600 foreign-earned income from personal service can be excluded

Can exclude up to – of employer-provided for an housing come out of amount exceeding $15,616

Must have tax home in foreign country, and be outside US for 330 days during any 12 consecutive months

Question 4

Controlled Taxpayers and Transactions –

Answer 4

An affiliated group of business having operations in several countries and conducting sales between affiliates could have a pricing structure that

i. intentionally or unintentionally understates income in some or all of these countries, including the United States, and
ii. results in some countries not receiving as much income tax.

Question 5

Controlled Taxpayers and Transactions – Controlled Taxpayer

Answer 5

Controlled taxpayer = 1 of two or more taxpayers owned or controlled directly or indirectly by the same interest
– Includes taxpayer that owns or controls the other taxpayers

Uncontrolled taxpayer = anyone often one more taxpayers not owned directly or indirectly by the same interests

Control = any kind of control, direct or indirect whether legally enforceable or not, and however exercisable or exercised, including control resulting from the actions of two or more taxpayers acting in concert or with a common goal or purpose.

Taxpayer = any person, organization or business, whether or not subject to any tax imposed by the IRC.

Question 6

Controlled Taxpayers and Transactions – Controlled Transaction

Answer 6

Control transaction or transfer = transaction or transfer between two or more members of the same group of control taxpayers.
Uncontrolled transaction = any transaction between two or more taxpayers that are not members of the same group of controlled taxpayers

Uncontrolled comparable = the uncontrolled transaction of taxpayer that is compared, under any applicable pricing methodology, with a controlled transaction or taxpayer

Question 7

Controlled Taxpayers and Transactions – IRS adjustments

Answer 7

To prevent the evasion of taxes, or to clearly reflect the income of two or more control taxpayers, the IRS adjusts (up or down) gross income, deductions, credits and allowances between or among the taxpayers.

Adjustments include the ability of the IRS to
– Modify basis of assets
– Require taxpayer to recognize income was respected and otherwise tax-free transaction

Adjustments are applied to controlled transactions and transfers to make them consistent with results of uncontrolled taxpayers engage in activity in an arms’ length transaction

Courts will reverse adjustments if controlled taxpayer can show the transactions were at arms’ length

Question 8

Controlled Taxpayers and Transactions – Avoidance of Penalties

Answer 8

Taxpayer can avoid the substantial valuation misstatement and gross valuation misstatement penalties using the following:

1. Section 482 study based on allowable pricing methods
2. Section 482 study not based on allowable pricing method
3. Transactions solely between foreign corporations

Question 9

Controlled Taxpayers and Transactions – Avoidance of Penalties: Section 482 study based on allowed pricing methods

Answer 9

Use method set forth by U.S. Treasury regulations that is reasonable under particular circumstances

Show prices for controlled transactions and transfers are in accordance with method

Complete study by date income tax return filed

Question 10

Controlled Taxpayers and Transactions – Avoidance of Penalties: Section 482 study not based on allowable pricing methods

Answer 10

Show that selected method would clearly reflect income

Show that allowable methods would not clearly reflect income

Complete study by day income tax return filed

Question 11

Controlled Taxpayers and Transactions – Avoidance of Penalties: Transactions solely between foreign corporation

Answer 11

Show that net increase in federal tax is due to transactions between foreign corporations that do not involve US income sources or taxable income effectively connected with the conduct of trade or business within the United States

Question 12

Controlled Taxpayers and Transactions – Competent Authority

Answer 12

Taxpayer request IRS and foreign tax authorities together determine appropriate transfer price so that taxpayer not taxed twice on same result

Can make request after IRS action results in taxation that is inconsistent with provisions of any applicable treaty

Question 13

Controlled Taxpayers and Transactions – Advance Pricing Agreement (APA) Program

Answer 13

RS and taxpayer get together to resolve actual or potential pricing issues

APA is binding contract between IRS and taxpayer

Issues agreed on
– Transfer pricing method
– Selecting comparable uncontrolled companies or transactions
– Years agreement applied to
– Adjustment to comparables because of differences with taxpayer
– Constructing range of arms’ length results
– Testing results during APA period
– Critical assumptions

Question 14

State Income Tax – Types of State and Local Taxes

Answer 14

Sales taxes = Levied on tangible personal property and some services

Use taxes = Levied on the use of tangible personal property that was not purchase in the state

Property taxes

Franchise tax = Levied on privilege of doing business in a state

Excise tax = Levied on the quantity of an item or sales price

Unemployment tax

Incorporation fees = For incorporating in a state or registering to do business in a state

Question 15

State Income Tax – Jurisdiction to Tax

Answer 15

4 test to determine jurisdiction to tax

1. Business activity must have substantial nexus with the state
2. Tax must be fairly apportioned
3. Tax cannot discriminate against interstate commerce
4. Tax must be fairly related to services that the state provides

Question 16

State Income Tax – Jurisdiction to Tax: Nexus

Answer 16

Nexus = the degree of the relationship that must exist between a state and a foreign corporation (i.e. taxpayers not domiciled or incorporated in the state) for the state to have the right to impose a tax.

Nexus does not exist if the activity in the state is limited to:
– Solicitation of orders of sales of tangible personal property that are approved and shipped from outside the state
– Advertising

The following activities are usually sufficient to establish nexus with a state if they occur in the state:
– Approving/accepting orders
– Hiring/supervising employees other than sales staff
– Installation
– Maintaing an office or warehouse
– Office maintained by independent – contractor does not establish nexus
– Providing maintenance or engineering services
– Making repairs
– Investigating creditworthiness or collecting delinquent accounts
– Providing training for employees other than sales staff

Question 17

State Income Tax – Business vs. Nonbusines Income

Answer 17

If more than one state has nexus to tax the income of a business entity then the income must be apportioned among the state

Income must be designated as business or nonbusiness income
– Business income apportioned among all states corporation does business
– Nonbusiness income allocated to state of incorporation

Business income
– Generated from business’ regular operations
F– rom sales of property that is an integral part of the business

Nonbusiness incomes includes investment income and income from transactions not part of regular operations
– investment income generated by regular business operations is business income

Question 18

State Income Tax – Apportionment of Business Income

Answer 18

Business income is apportioned among the state based on apportionment factor such as sales, property, payroll.

States have great flexibility to choose an apportioning formula

Most states require that corporations apportion and allocate federal taxable income before NOL deductions and before dividends received deduction
– For corporations, amount shown on Line 28 of page 1 of Form 1120

Income apportioned to a state is the product of the apportionment factor and the portion of Line 28 income which is apportionable, business income.

Question 19

State Income Tax – Controlled Taxpayers

Answer 19

Most states don’t have a statute similar to the IRC’s status authorizing the IRS to make controlled taxpayer adjustments with respect to transfer pricing issues. Instead they have a statute allowing the state taxing authority to require a combination of related members if such combination will better reflect the extent of business done within the state.