Presentation on theme: "International Tax JurisdictionBasic Concepts Key issues governments must resolve when taxing cross-border trade -- What persons to tax? -- What income."— Presentation transcript:
International Tax JurisdictionBasic Concepts Key issues governments must resolve when taxing cross-border trade -- What persons to tax? -- What income to tax? Factors that trigger taxation
Personal relationship Country of incorporation or residence Economic relationship Country in which a business has income producing assets or activities
Outbound Transactions Foreign Source Income DomesticForeign CorporationOperations Foreign Investment Foreign Investment U.S. persons (§7701)* Foreign Source Income U.S. citizens Resident aliens Domestic corporations Domestic Partnerships
Inbound Transactions U.S. Source Income ForeignU.S. CorporationOperations U.S. Investment U.S. Investment Foreign Persons (§7701)* US Source Income Non resident aliens Foreign corporations Foreign partnerships
U.S. Taxation of Outbound Transactions Foreign Source Income DomesticForeign CorporationOperations Foreign Investment Foreign Investment Credit System Low-tax foreign countriesU.S. collects residual U.S. tax High-tax foreign countriesU.S. collects no tax and credit is limited to US tax on foreign income Major Exceptions Deferral privilege (subject to Subpart F, PFIC and FPHC regimes) Foreign earned income exclusion (§ 911)
U.S. Taxation of Inbound Transactions U.S. Source Income ForeignU.S. CorporationOperations U.S. Investment U.S. Investment Two-pronged territorial system U.S. branch operationsNet basis tax on effectively connected income Passive foreign investorsGross basis withholding on U.S. source non business income Major exceptions Capital gains and portfolio interest exemptions U.S. real property interests (FIRPTA) Treaty reductions
Computing the Foreign Tax Credit Procedure Compute creditable taxes (All or Nothing) Compute foreign tax credit limitation Credit = Lesser of creditable taxes or FTCL Excess credits: Back 2 years, forward 5 years Computing creditable taxes (Step 1 above) Qualifying (by treaty) foreign levies (§§ 901,903) Taxpayers entitled to claim a credit (§ 901) Currency translation (average exchange rate for year) (§ 986) Cash v. accrual basis accounting (§905) [Accrual method election available]
Foreign Tax Credit Limitation (§904) Purpose Limit credit to U.S. tax on foreign income Credit cannot exceed U.S. tax on U.S. source income Formula Pre-credit =Foreign source taxable income U.S. tax Total taxable income
Excess Credit vs. Excess Limitation Impact of Foreign Tax Rate Facts: Domestic corporation has a foreign branch. (Note: Branches include legal entities that are disregarded under the check-the-box regulations) Total income of $ 100 is attributable entirely to foreign branch. U.S. tax rate = 35% Case 1: 20% foreign tax rate Excess Limitation U.S. tax return Taxable Income$ 100 Tax rate 35% Pre-credit tax $ 35 Credit (limit) 20 U.S. tax $ 15 Foreign tax return Taxable income$ 100 Tax rate 20% Foreign tax$ 20*
Excess Credit vs. Excess LimitationPlanning Issues Excess limitation position (Subpart F issues) Tax on foreign income equals foreign tax + residual US tax Planning: Defer residual US tax Excess credit position (§ 861 planning) Tax on foreign income equals higher foreign tax Planning Reduce foreign taxes Increase allowable credit
Strategies for Eliminating Excess Credits Foreign tax reduction planning (discussed later in the course) Foreign tax credit limitation planning (§ 861) Increase foreign source portion of total taxable income Transfer title overseas on export sales Reduce expenses apportioned to foreign source income Cross-crediting Blend low and high tax foreign source income within the same Foreign tax credit limitation basket.
Cross CreditingAn Example Case 1: Domestic corporation has a branch in country X Total income of $ 100 is attributable entirely to branch in X Tax rates: U.S. = 35% and X = 50% Question: What is the amount of the excess credits? Foreign income taxes (50% of $ 100)$ 50 Average foreign tax rate 50% Limitation: (a) Total taxable income$ 100 (b) Pre-credit U.S. tax ($100 x 35%) 35 (c) Foreign source taxable income 100 Limitation [b x (c ÷a)] 35 Excess credits $ 15
Cross CreditingExample (Continued) Case 2: Domestic corporation also has branch in country Y Branch generates $ 100 profit Country Y tax rate is 25% Question: What is the amount of the excess credits? Foreign income taxes (50% x $ 100) + (25% x $ 100) $ 75 Average foreign tax rate ( $ 75 ÷ $ 200) 37.5% Limitation: (a) Total taxable income ( $ $ 100)$ 200 (b) Pre-credit U.S. tax ($ 200 x 35%) 70 (c) Foreign source taxable income 200 Limitation [b x (c ÷ a)] ` 70 Excess credits $ 5
§904(d) Separate Income Limitations or BasketsPrincipal Features Passive income (usually low tax income) mini-baskets High withholding tax interest Dividends from >10%/<50% companies Financial services income (banks) Shipping income (low tax jurisdictions) General limitation income, which includes most active business profits (e.g. e- commerce) These are usually high income tax jurisdictions
Separate Income Limitations (or Baskets) Formula Pre-credit U.S. tax X Separate basket foreign tax inc. Total taxable income Computation Items of foreign source income and deduction must be allocated among the baskets Foreign income taxes must be allocated among the baskets
Form 1118 Foreign Tax Credit Who must file Corporations claiming FTC File separate 1118 for each basket Contents Sch A--Separate basket taxable income Sch B--Foreign tax summary and credit computation Schs C, D, and E--Deemed paid credit Schs F, G, and H--Supporting computations
Dividend Repatriations from a Foreign Corporation to a U.S. ParentTax Consequences Foreign withholding taxes Pre-credit U.S. tax on dividend income Foreign tax credits §901 direct credit for withholding tax borne by U.S. parent (branch arrangements, not a corporation) net §902 deemed paid credit for taxes paid by a foreign subsidiary (the dividend from the subsidiary is net of the withholding tax)
The Deemed Paid CreditAn addition to the actual withholding tax paid Rationale: Tax parity between branches and subsidiaries (for branches all income is combined in gross income; for foreign subsidiaries the income is not combined) Qualification requirements (§902) domestic Shareholder must be a domestic corporation (does not include S corporations) Shareholder must own 10% or more of voting stock Shareholder must receive dividend distribution §78 Gross-up income Equals amount of deemed paid credit Tracing foreign taxes to dividends (see next slide)
Pooling Approach of §902(a) Foreign Dividend received Deemed = corporations X by shareholder Paid Credit post-1986 Foreign corporations foreign income 1986 undistributed taxes E & P (excluding the current dividend)
FTCL basketing rules of §904(d) Dividends received from a CFC Controlled Foreign Corporation: More than 50% ownership requirementfollows §902 (a) pooling approach Dividends received from a 10/50 corporation each Look-through rule applies; Dividends from E & P accumulated before 2003 are assigned to a single company basket that applies to all 10/50 companies. Dividends from each 10/50 corporation from E & P accumulated after 2002 is assigned based on separate baskets. Definition of 10/50: The domestic corporation owns between 10% and 50% of the foreign corporation
Mechanics of CFC Look-through Rule Step 1 Post-1986 undistributed Portion of dividend= E & P attributable to basket attributable to basket Total post –1986 undistributed E & P Step 2 Deemed paid Portion of dividend taxes associated = attributable to basket with basket Total post –1986 undistributed E & P attributable to basket
Deemed Paid Credit – Lower Tier Corporations
Deemed Paid Credit – Lower Tier Corporations (Continued) Qualification requirements Minimum 10% direct ownership at each level Minimum 5% indirect ownership through chain Dividend Distributions up to U.S. parent Number of qualifying tiers Historically limited to 1 st, 2 nd, & 3 rd tiers TRA Extended to 4 th, 5 th, & 6 th tiers
Dividend Repatriations -- Planning Tax consequences Low tax countries: Residual U.S. tax High tax countries: Excess credits Annual repatriation program Coordinate dividends to exploit cross- crediting Structure investments to minimize 10/50 company baskets Use tax treaties to minimize withholding taxes
Repatriating Profits – Dividends vs. Interest TaxpayerAttributeDividendInterest Foreign Subsidiary Host country deduction NoYes U.S. parentForeign withholding tax Yes U.S. parentU.S. taxable income Yes U.S. parent§901credit for withholding tax YesYes, §904 (d) applies No gross-up, interest is an expense U.S. parent§902 credit for subs foreign taxes YesNo
Earnings Stripping – An Example Ps U.S. tax return Dividend $ 50 Gross-up 50 Taxable income $100 Tax rate. 35 Pre-credit tax $ 35 Credit (limitation) (35) U.S. tax $ 0 Ss foreign tax return Profit pre-interest $ 100 Interest expense 0 Taxable income $ 100 Tax rate.50 Foreign tax $ 50 Facts: P, a domestic corporation, owns 100% of S, a foreign corporation S Profit before interest and taxes = $ 100 Tax rates: U.S. = 35%, Foreign = 50% Assume no foreign withholding tax on interest or dividends Conclusion: Total tax = $ 50 (earnings taxed once at the higher foreign rate)
Earnings StrippingExample (Continued ) Ps U.S. tax return Interest Income $ 100 Gross-up 0 Taxable income $ 100 Tax rate.35 Pre-credit tax $ 35 Credit (0) U.S. tax $ 35 Ss foreign tax return Profit pre-interest $ 100 Interest expense 100 Taxable income $ 0 Tax rate.50 Foreign tax $ 0 Facts: Earnings repatriated via interest payments once Total tax = $ 35 (Earnings taxed once at the U.S. rate)
Importance of Sourcing Rules U.S. persons Taxed on worldwide income Foreign source income impacts foreign tax credit limitation Foreign persons Taxed only on U.S. source income
Maximizing the Foreign Tax Credit Limitation (§904) Foreign tax Foreign source credit = Pre-credit X taxable income limitation U.S. tax Total taxable income How to increase the limitation? Gross Income Recharacterize as foreign source income for U.S. tax purposes Deductions Recharacterize as U.S. source for U.S. tax purposes
Overview of the Sourcing Process Goal: Determine geographic origin of income Two step process similar to allocation and apportionment of state income taxes Gross Income (§ 863 to § 865) Step 1: Determine statutory category Step 2: Apply specific category rule Deductions (Reg ) Allocate Step 1: Allocate to a related class of gross income Apportion Step 2: Apportion based on factual relation of deductions to gross income.
Sourcing RulesThe General Rules (§§861, 862) Income Sourced in the United States (§861) InterestInterest received from the U.S. government, District of Columbia and from non-corporate U.S. residents or domestic corporations DividendsDividends received from domestic corporations (other than certain possessions corporations) Personal Services Source is determined by the location in which the services are performed (inside or outside the United States) Rents and RoyaltiesFor tangible property, the country where the property is located, for intangible property, the country where the property is used. Sale or Exchange of Real PropertySource is determined by the location of the property
Sourcing RulesThe General Rules (Continued) Sale of Personal PropertyFactors for Consideration Whether the property was produced by the seller. The type of property sold (e.g. inventory of capital asset) The residence of the seller §865Sale of Personal Property Other Than Inventory Sourced at the Residence of the Seller Gain on sale of depreciable personal property is sourced according to the prior depreciation deductions to the extent of the deductions. An excess is sourced the same as the sale of inventory. Gain on sale of intangibles is sourced according to prior amortization deductions to the extent of the deductions. Contingent payments are sourced as royalty income. Gain attributable to an office or fixed place of business maintained outside the U.S. by a U.S. resident is foreign-source income Sourcing of losses depends on the nature of the property (Reg (e)(7))
Sourcing Rules for Inventory purchased inventory §§ 861(a)(6) & 865 Sale of purchased inventory is sourced in the country where the sale takes place. The sale is deemed to take place when title passes (Reg (c)) produces When the seller produces the property the income must be apportioned between the country of production and the country of sale. Referred to as §863 (b) income Seller must source the gross income under a 50/50 allocation method (see next slide) unless another method is elected. Other methods are independent factory price and separate books and records.
50-50 Method for Sourcing Sales Apply to Gross Profit, 50% to Sales and 50% to Property The sales factor: Export sales where title passes abroad Total export sales Definition of export sales –Goods produced in the U.S. and sold for use, consumption or disposition abroad
50-50 Method: The Property Factor Average adjusted basis of foreign production assets Average adjusted basis of all production assets Denominator Includes assets used to produce inventory in the U.S. for sale abroad Prorate assets used to produce inventory sold domestically and abroad Excludes cash, receivables, inventory distribution and marketing assets Average basis = (Beginning of year + end of year) ÷ 2 Numerator Assets in dominator that are physically located abroad Numerator equals $0 if taxpayer has no foreign manufacturing facilities or owns foreign facilities through foreign subsidiaries.
Sourcing Gross Income under §861 Some Important Exceptions Interest Income Certain interest received from a U.S. corporation that earned 80 percent or more of its active business income from foreign sources over the prior three period is treated as foreign source income. [80/20 corporations] Income received on amounts deposited with a foreign branch of a U.S. corporation is also treated as foreign source income High withholding tax interest is treated as a separate basket for FTCL purposes Dividends If 25% or more of a foreign corporations gross income for the three tax years immediately preceding the current tax year was effectively connected with the conduct of a U.S. trade or business, a special rule applies. The U.S. portion of gross income is equal to the proportion of gross income effectively connected with the conduct of a U.S. trade or business for the immediately preceding three-year period. There is a withholding exemption for 80/20 corporations described above Normally passive income for FTCL purposes, but special treatment for CFCs, 10/50 corporations, DISCs and FSCs..
§862 Income Sourced Outside the United States Not as detailed or Specific as §861 If income is not U.S. source income, then it is foreign source income. §862 applies to the following: Interest Dividends Compensation for personal services Income from the use or sale of property Other income
Source Rules for Deductions (Treasury Reg ) Step 1 Step 1: Allocation Potential Classes of Gross Income Compensation for services Gross income from business Royalties Gains on dealings in property Interest Rents Dividends
Source Rules for Deductions (Treasury Reg ) Step 2 Step 2: Apportionment between U.S. and foreign source gross income Potential Apportionment Bases Gross income Gross sales Unit sales Cost of goods sold Profit contributions Expenses incurred Assets used Salaries paid Space used Time spent
Special Apportionment Rules Interest expensesee next slide Research and experimentation expenditures ordinarily are considered to be definitely related to all income reasonably connected with the relevant broad product category and are allocable to all items of gross income as a class [i.e., sales, royalty, and dividend income] related to that product category. After allocation of the research expenses, the expense is apportioned between the statutory and residual groupings of income, using either the sales (50/50) method or the optional gross income method. (Reg ) State income taxes are considered definitely related and allocable to the class to which the asset would normally generate gross income. (Reg (e)(65)(i) Net operating losses are allocated and apportioned in the same manner as the deductions giving rise to the NOL deduction. Reg (e)(8)
Special Apportionment Rules--Continued Stewardship expensesIf services are provided for the benefit of the corporation as an investor, the services may be of a stewardship or overseeing character for which no charge is made. Deductions resulting from stewardship or overseeing functions are considered definitely related and allocable to dividends received or to be received from the related corporation. Reg (e)(4) Losses on sales of propertyThe deduction allowed for loss recognized on the sale of a capital asset or § 1231 asset is considered definitely related and allocable to the class to which the asset would normally generate gross income. Reg (e)(7) and § 865 (j) Legal and accounting fees are normally definitely related and allocable to the class of gross income for which the services are related. Reg (e)(5)
Source Rules for Interest Expense Fungibility principle Allocate interest to all gross income even if borrowing relates to specific asset Apportionment base Two methods availablefair market value or tax book value §864 (e)(2) Affiliated groups Treated as a single corporation for purposes of apportioning interest expense
Worldwide Effective Tax RateWhy It is Important Impact reported earnings Impacts cash flow Impacts evaluation of tax director
Examples of Impact of Foreign Operations on Effective Tax Rates CaterpillarU.S. statutory rate 35.0% FSC benefit (3.2%) Other` (1.2%) `Effective tax rate 30.6% Exxon/MobilU.S. statutory rate 35.0% Operations in high tax countries15.5% Other(6.2%) Effective tax rate44.3% PfizerU.S. statutory rate 35.0% Operations in low tax countries (5.5%) Operations in Puerto Rico(2.2%) Other(2.5%) Effective tax rate24.8%
Planning for Foreign Operations by a U.S. Domestic Corporation Goal: To minimize worldwide effective tax rate on foreign source income U.S. tax on foreign income Deferral Foreign sales corporations and extraterritorial income exclusion Foreign taxes Reducing foreign taxes Maximizing allowable U.S. credit
Taking Advantage of DeferralAn Example
Taking Advantage of Deferral- -Continued Deferral = 25% residual U.S. tax Financial reporting: Can treat as permanent difference that increases current earnings (APB 23) Other examples of low tax countries: Singapore and Hong Kong Restrictions on deferral Arms length transfer price Subpart F §367 outbound toll charge
Operating in High Tax Foreign Countries – Example
Operating in High Foreign Tax Countries--Continued Problem: Excess foreign tax credits Other examples of high tax countries: Canada and Germany Planning: Increase allowable credits Reduce foreign taxes
Contract Manufacturing and CommissionairesAn Example
Example (continued)-- Commissionaire Activities Acts as agent for undisclosed principal, Worldco (contract is between commissionaire and customer) Worldco retains title until it passes to customer Worldco finances receivables and bears credit risk Marketing intangibles remain with Worldco Tax consequences Commissionaires income reduced commensurate with reduced responsibilities and risks Commissionaires income determined using cost-plus approach Commissionaire does not create a permanent establishment for Worldco
Example (continued)Contract Manufacturer Activities Processes component materials into finished products under contract with Worldco Worldco retains title to inventory Profit and loss risk remains with Worldco Manufacturing intangibles remain with Worldco Tax consequences Contract manufacturers income reduced commensurate with reduced responsibilities and risks Contract manufacturers income determined using cost- plus approach Contract manufacturer does not create a permanent establishment for Worldco
Foreign Tax Reduction PlanningHolding Companies (Example) Assume U.S. parent corporation R.S.A. subsidiary Dutch holding company R.S.A. makes dividend distribution to U.S. parent Without the Dutch Holding Company The R.S.A. dividend subject to 25% withholding tax. Dutch Holding Company The R.S.A. dividend subject to 5% withholding tax. The Dutch holding company dividend is subject to an additional 5% withholding tax.
Foreign Tax Reduction PlanningEarnings Stripping Debt financing for foreign subsidiaries Interest expense deduction in host country Possible reduction in foreign withholding taxes Possible increase in foreign tax credit limitation (subject to CFC netting rule) Transfer pricing and technology charges Inventory sales Technology charges Management fees
Foreign Tax Reduction PlanningIncentives in Local Tax Laws Examples Ireland10% rate for manufacturing SingaporeTax holidays for high-tech companies Puerto Rico2% to 7% rate for manufacturing BelgiumSpecial tax breaks for coordination, service and distribution centers
Hybrid Entities Classification of Foreign Entity Foreign tax purposes, a corporation U.S. tax purposes, a partnership or branch A U.S. tax shelter?
Reg The Check-the-Box Regulations Effective date: January 1, 1997 Goal: Simplify entity classification New approach: Per se corporations (e.g. U.K plc, German AG, French SA, Dutch NV) classified as corporations For all other entities, taxpayers chooses classification via check-the-box procedure Benefits: Enhances ability to use branches and partnerships in international tax planning
Tax Benefits of a Hybrid Entity Avoids 10/50 company basket problems Allows flow-through of foreign losses, subject to dual consolidated loss limitations Allows flow-through of foreign tax credits to S corporation or partnership shareholders, a direct §901 foreign tax credit Solves §902 multiple tier problems Avoids Subpart F through the use of super holding companies and interest transfers from high tax country hybrid to a low tax country finance country hybrid What is the next frontier of effective tax planning?
What is Transfer Pricing?
What is Transfer Pricing-- Continued transfer price Houseware Distributors, Inc (Parent) must set an appropriate transfer price for the sale of the grill protectors to Houseware Distributors, Pty. (the Japanese subsidiary). Group profit = $25 ($100 - $60 - $15) Impact of alternative transfer prices: Transfer price of $ 60 would allocate entire $25 profit to foreign subsidiary Transfer price of $ 85 would allocate entire profit to U.S. parent Transfer price between $ 60 and $ 85 splits the profit between the U.S. parent and the foreign subsidiary.
§ 482 Goal: Clearly reflect income of affiliated corporations engaged in inter-company transactions. Standard: Arms-length price (or market value) standard for evaluating transfer prices Practical difficulty: Market values are highly judgmental and depend on the facts and circumstances. Result: Transfer pricing is the most contentious area of audit and litigation controversy in international taxation. Other observations: Many of the larger states have similar provisions to § 482.
Principal Factors for Assessing Comparability of Controlled and Uncontrolled TransactionsReg Functions performed by the parties involved Contractual terms governing transaction Risks assumed by each party Economic or market conditions in which parties conduct business Nature of property or services transferred in transaction
Transfer of Intangibles (Reg )
Transfer of Intangibles (Reg )--Continued Problem No comparables due to uniqueness of intangibles Commensuratewith income Congressional response Commensurate with income requirement Comparableuncontrolled transaction Pricing methods Comparable uncontrolled transaction method Comparableprofits method Comparable profits method Profit split method Profit split method
Comparable Profits Method (Reg ) 1. Determine which affiliate will be the tested party. 2. Obtain data regarding comparable uncontrolled parties. 3. Choose profit level indicator, such as operating profit/sales or operating profit/operating assets. 4. Construct arms length range of comparable profits for tested party 5. Make adjustment if reported profit lies outside arms length range.
§662(e) Transfer Pricing Penalties Rationale Promote more voluntary compliance with arms length standard Promote better documentation of transfer pricing policies 20% penalty applies if: Transfer price 200% (or 50%) of arms length price (transactional penalty), or Net §482 adjustment > either $ 5 million or 10% of gross receipts (net adjustment penalty)
§662(e) Transfer Pricing Penalties-- Continued 40% penalty applies if: Transfer price 400% (or 25%) of arms length price, or Net §482 adjustment > either $ 20 million or 20% of gross receipts Reasonable cause exception To avoid net adjustment penalty, taxpayer must have created contemporaneous documentation DHL Corporation, TC Memo IRSs imposition of §6662 penalty upheld in court
How Should Taxpayers Respond? Develop documentation that supports methodology and results Principal documents (§ ) Nature of business Economic and legal environment Organizational structure Controlled transactions Pricing methods selected, rationale Comparables used Economic analysis and projections Assess risk of transfer pricing adjustment Dollar magnitude of inter-company transactions Percentage of worldwide profits attributed to low-tax foreign subsidiaries Consider transfer pricing study or Advance Pricing Arrangement
ReviewU.S. Taxation of Foreign Subsidiaries Tax Jurisdiction Excluded from U.S. consolidated return, can [by election] include Canadian and Mexican corporations in the group Taxed only on U.S. source income Profit Reparations U.S. parent can not claim the dividend received deduction U.S. parent can claim a §902 credit FTCL basketing rules: 10/50 company or CFC look-through rule Transfer Pricing Must use arms-length prices.
Shifting Income to a Foreign Base CompanyAn Example
Anti-Deferral Provisions Concept Deny deferral of tainted foreign earnings Simultaneously allow deferral for active foreign business profits Specific regimes Foreign Personal Holding Companies (enacted in 1937, pocket book overseas) Subpart F Subpart F (enacted in 1962) Passive Foreign Investment Company (enacted in 1986), discourages investment in foreign mutual fund companies
Subpart F (§§ ), Controlled Foreign Corporations CFC defined U.S. shareholders own >50% of stock, by vote or value U.S. shareholder is a U.S. person that owns 10% or more of stock Subpart F inclusion (deemed dividend) Subpart F income Investments in U.S. property
Subpart F Income (§§ ) FTCL basket is determined by the type of income earned by the subsidiary Foreign base company sales income Income from the sale of goods Goods are purchased from or sold to a related person CFC neither manufactures the product or sells it for sells it for use in CFCs country of incorporation. CFC can buy in or sell in country of incorporation and can also elect out of Subpart F in high tax jurisdictions. Foreign base company services income Fees for services performed outside CFCs country of incorporation for a related person. Insurance income Income from insuring risks outside the CFCs country of incorporation (i.e. lower risks) Foreign personal holding income Passive investment income such as dividends, interest, rents, royalties and capital gains Foreign base company shipping income Foreign base company oil-related income
Taxation of U.S. Shareholders U.S. Shareholders Receive a Deemed Dividend from the Controlled Foreign Corporation Year in which CFC has Subpart F Income U.S. shareholder is taxed on deemed dividend (§951) U.S. shareholder can claim §902 credit (§960) FTCL basketing rule: Same character as underlying Subpart F income Actual dividend distributions in subsequent years (§959) Traced first to CFCs previously taxed income (PTI) Receipt of PTI is a tax- free return of capital
Earnings Invested in U.S. Property by the Controlled Foreign Corporation (§956) Concept: Constructive dividend of active foreign business profits Treatment: Current inclusion under Subpart F Transactions triggering §956 inclusions CFC makes loan to U.S. shareholders (includes guarantees) CFC purchases stock issued by U.S. shareholders CFC purchases tangible property located in U.S. CFC purchases right to use intangible property is U.S.
Form 5471 Information Return of a U.S. Person with Respect to a CFC Who must file Shareholder of CFC Contents Sch. A – Stock of CFC Sch. B – U.S. shareholders Sch. C and F – Financial statements Sch E, H and J – Foreign taxes and E&P Sch. I – Subpart F income Sch M – Inter-company transactions Sch. O – Changes in stock ownership $ 10,000 penalty for failure to file TRA of 1997 added similar reporting requirements for foreign partnerships controlled by U.S. persons
Foreign Personal Holding Company (§§ ) Concept: Incorporated pocketbook of wealthy U.S. citizens Definition of FPHC 5 or fewer U.S. citizens own 50% or more of stock 60% or more of gross income is FPHC income Deemed Dividend = Undistributed FPHC income
Passive Foreign Investment Company (§§ ) PFIC defined: 75% or more of gross income is passive investment income or 50% or more of assets produce passive income Taxation of U.S. shareholders Qualified Electing Fund election Current taxation or Excess distribution: Pay deferred tax + interest
ReviewSubchapter C Non-recognition Provisions Concept Tax-free treatment of changes in legal form, but not the underlying substance, of an investment Any appreciation not taxed currently is preserved for taxation in the future through carryover basis Non-recognition Transactions Incorporations (§351): Transfers of appreciated property to a controlled corporation Subsidiary liquidations (§332): Transfer of appreciated property to parent corporation in complete liquidation Reorganizations (§368 (a)(1)(A) and (a)(1)(D): Acquisitive (e.g., merger) and divisive (e.g., spin-off)
Illustration of Tax Avoidance Opportunities Created by Outbound Transfers to Foreign Corporations
Deemed Sale Regime of §367 (a) U.S. parent transfers appreciated property to a foreign subsidiary corporation. Results is an outbound toll charge include on the parents U.S. income tax return. Impact of §367(a): Recast tax-free transfers as taxable sales active Exception: Assets used in active foreign business (§367(a)(3)(A)) Exception does not apply to Inventory, receivables, currency and intangibles (§367 (a)(3)(B)) Foreign branch with previously deducted losses (§367 (a)(3)(C)) To the extent of depreciation recapture on U.S. assets only (Reg (a)-4T(b)) Reporting requirement: Form 926
Deemed Royalty Regime of §367(d) U.S. parent transfers a patent to a foreign subsidiary, and receives a deemed royalty Deemed Actual Tax Attribute Royalty Royalty Commensurate with income requirementYes Yes Foreign source incomeYes Yes Foreign tax deduction No Yes Foreign withholding taxes No Yes (treaties, however, often provide exemption)
Illustration of Tax Avoidance Opportunities Created by Inbound Liquidation of CFC Facts CFC distributes its accumulated E & P to USP in liquidation U.S. tax consequences, ignoring §367 CFCs earnings were not taxed currently (deferral privilege) USPs receipt of the distribution is tax free under §332 Any residual U.S. tax is permanently avoided
Deemed Dividend Regime of §367(b) As a result of the CFC liquidation the U.S.Parent will pay an inbound toll charge on its U.S. tax return. Bad news: USP must include in income the lesser of (a) Dividend = CFCs accumulated E & P (b) Capital gain = MV of distribution – USPs basis in stock Good news: USP can obtain §902 credit with respect to any dividend income
§367 SummaryImportant to Consider the Source of the Property and Where It Ends Up Code SectionSource/EndOutcome §367 (a)Start in the U.S. and ends overseas Bad, unless exception §367 (b)All inbound transactions Good, unless bad §367 (d)U.S. to Offshore (Intangibles) Bad
Other Non-recognition Transactions Subject to a Toll Charge U.S. corporation transfers appreciated. property to a foreign entity. Outbound transfers to non-corporate entities TRA 1997 added §721(c): Transfers to partnerships with foreign partners Also added §684: Transfers to foreign estates and trusts Expatriating liquidation of U.S. subsidiary into foreign parent Other inbound and foreign-to-foreign transfers involving CFCs
Overview of Inbound Transactions A foreign corporation invests in U.S. assets and receives U.S. source income. General Rules Withholding tax regime for U.S. source non-business income (or FDAP (fixed or determinable, annual or periodic) [e.g. interest, dividends, rents, and royalties but not capital gains] Net basis taxation on U.S. source business profits or ECI (effectively connected income) Special Rules Treaty exemptions and reductions (e.g. UK 5% dividends, 0% interest and royalties Anti-earnings stripping rules (§163(j)) U.S. real property interests (§897) Branch profits tax (§884)
U.S. Taxation of Non-Business Income General Rules Base = Gross amount of U.S. source income Statutory rate = 30% Collection via withholding by U.S. payer Exceptions Capital gains Portfolio interest income (10%+ shareholders excluded) U.S. real property interest Treaty withholding rates W8 BEN available for non-resident aliens
Repatriating Profits from Domestic Subsidiaries Goal: to minimize U.S. taxes (subsidiary-level and shareholder-level, and foreign taxes) From the U.S. subsidiary perspective The issue is whether the remittance to the foreign parent corporation creates a U.S. tax deduction From the foreign parent perspective What is the U.S. withholding tax rate on the remittance? Are foreign taxes owed on the remittance?
§163(j)--Anti-Earnings Stripping Provisions §163(j) applies to U.S. subsidiaries that have: Debt to equity ratio in excess of 1.5 to 1 Disqualified interest payments, and Excess interest expense Definition of disqualified interest Interest paid to a related party and exempt from U.S. tax (or subject to reduced withholding tax rate) Interest paid to unrelated party (e.g. U.S. bank), but guaranteed by related party (e.g. foreign parent) and exempt from U.S. withholding tax
Anti-Earnings Stripping Provisions (Continued) Disallowed interest expense deductions are limited to the amount of excess interest Definition of excess interest Net interest expense – 50% (adjusted taxable income) Net interest expense = interest expense – interest income Adjusted taxable income = Taxable income + Net interest expense + NOL carryovers + Depreciation expense +/- Changes in receivables and payables Excess interest is a cash flow concept Indefinite carry-forward of disallowed interest expense deductions
Planning for Section 163 (j) Remove foreign parents guarantee Reduce U.S. subsidiarys debt-to-equity ratio below 1.5 to 1 Increase U.S. subsidiarys adjusted taxable income without increasing taxable income U.S. subsidiary should buy assets rather than leasing them.
Form 5472: Information Return of a Foreign-Owned U.S. Corporation Who must file 25% foreign-owned domestic corporation Foreign corporation engaged in U.S. trade or business Contents 25% foreign subsidiaries Other related parties Transactions with foreign related parties Record maintenance requirements $ 10,000 annual penalty
Taxation of U.S. Real Property Interests For foreign investors, gains on sale of U.S. real property interests are taxed like effectively connected income. (§897) U.S. real property interests include: Land and buildings Mines, wells and other natural deposits Growing crops and timber Personal property associated with use of real property such as fences and moveable equipment
U.S. Real Property Interests (Continued) Foreign investors become shareholders in a U.S. domestic corporation which invests in U.S. real property. U.S. real property holding corporations Market value of U.S. real property holdings 50% of market value of all real property and business interests Purchasers of U.S. real property interests Obligation to withhold 10% U.S. tax on amount realized by foreign seller.
U.S. Taxation of Inbound Transactions A foreign corporation receives ECI and/or FDAP Two-pronged system for taxing foreign persons Passive foreign investors: Gross basis withholding tax U.S. branch operations: Net basis on ECI Focus here is on U.S. branch operations
Foreign Corporation Engaged in a U.S. Trade or Business Nexus Per IRC: Trade or business within U.S. Per Treaty: Permanent establishment within U.S. Tax base: Effectively connected income (§864(c)) U.S. source business income Selected types of foreign source business income Selected types of U.S. source non-business income Look back rules (10 years under §864(c)(7) Tax rate schedule: same as domestic corporation
§884The Branch Profits TaxRationale Goal: Mimic U.S. withholding tax on dividends paid by U.S. subsidiaries (Comparison of # 1 with # 2) 1. The U.S. subsidiary pays the corporate level U.S. income tax and remits a dividend to the Foreign parent corporation. The dividend is subject to U.S. withholding tax at the shareholder level. 2. The U.S. branch pays the corporate level U.S. income tax and remits a dividend equivalent amount to the Foreign parent corporation. The dividend equivalent amount is subject to the branch profits tax.
Computing the Branch Profits Tax Need formula for estimating dividend equivalent amount Under §884 (b) (A) Effectively connected E & P for the year (B) + Decrease in U.S. net equity (deemed distribution to foreign home office) or - Increase in U.S. net equity (deemed reinvestment in U.S. branch) = Dividend equivalent amount - Tax rate = 30% statutory rate subject to treaty reductions - Some Treaties eliminate the amount
Branch Profits Tax– An Example (Year 1) Year 1 Treaty rate on dividends (controlling shareholder) = 5 % Effectively connected E & P = $ 100 U.S. net equity: $1,000 at beginning of year $1,100 at end of year Branch profits tax calculation: Effectively connected E & P$ 100 Increase in U.S. net equity: Beginning of year$ 1,100 End of year 1,100 (100) Dividend equivalent amount$ 0 x 5% Branch profits tax$ 0
Branch Profits Tax: An Example (Year 2) Year 2 Treaty rate on dividends (controlling shareholder) = 5 % Effectively connected E & P = $ 100 U.S. net equity: $1,000 at beginning of year $1,100 at end of year Branch profits tax calculation: Effectively connected E & P$ 0 Decrease in U.S. net equity: Beginning of year$ 1,100 End of year 1, Dividend equivalent amount $ 40 x 5% Branch profits tax $ 2
§884 (f)Branch Interest Withholding Tax What is it? 30% withholding tax on interest payments Tax imposed on foreign payee, not the U.S. branch Creates tax parity between U.S. tax imposed on interest payments made by U.S. branches and U.S. subsidiaries Computation of tax: Reg defined interest payment Statutory exemptions (e.g. portfolio interest exemption) and reduced withholding rates apply
§884(f)--An Additional Provision, The Excess Interest Tax What is it? 30% tax on U.S. branchs excess interest Tax is imposed on U.S. branch, not the recipient of the interest payment Recapture provision designed to create symmetry between interest deductions and related interest income inclusions Computation of tax: Excess interest = Interest expense deducted in computing Effectively Connected Income (per § ) minus Interest payments subject to branch interest withholding tax [See Preceding slide] Reduced treaty withholding rates apply