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Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 Principles of Taxation Chapter 12 Jurisdictional Issues in Business Taxation
Slide 12-2 Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 Jurisdictional Issues Nexus - the right to tax Apportionment Permanent establishment in foreign country Worldwide taxation and foreign tax credits Blending high and low tax income Branch versus subsidiary Preventing abuse: Subpart F and transfer pricing
Slide 12-3 Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 State and Local Tax Taxation requires nexus - degree of contact between business and state legal domicile (there is nexus in the state where incorporated). physical presence: employees or real or personal property. (sales reps do not create nexus). economic nexus: regular commercial activity - law still unclear. Other issues: catalog sales, internet sales.
Slide 12-4 Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 Apportionment of state income How determine State X’s share of Corporation C’s taxable income? Under UDIPTA model, apportion based on 3- factor weights: sales payroll property About 1/2 of the state double-weight sales. This favors in-state businesses.
Slide 12-5 Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 International Business Transactions - jurisdiction Tax treaties govern the jurisdiction to tax as well as exceptions related to tax rates. Business activities are taxed by country of residence (incorporation) unless the firm maintains a permanent establishment. fixed location, such as an office of factory, with regular commercial operations. typically does not result from mere exporting
Slide 12-6 Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 International jurisdiction - continued Double taxation may result from two jurisdictions claiming right to tax the same income. U.S. taxes the worldwide income of its resident taxpayers (e.g., corporations legally incorporated in the United States). If the U.S. corporation has a branch that is doing business as a permanent establishment, both the foreign country and the U.S. will tax the branch income. What relief exists for double taxation?
Slide 12-7 Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 The Foreign Tax Credit In the U.S. (and other major trading partners), the relief comes from a foreign tax credit. Applies only to INCOME taxes. Reduce U.S. taxes by foreign income taxes paid. These rules are extremely complex, but this chapter teaches the basics.
Slide 12-8 Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 Foreign tax credit limitation The U.S. will only grant a credit up to the U.S. tax rate X foreign source taxable income. Equivalently, FTC limit = U.S. tax X foreign income / worldwide income. If the firm has paid more foreign tax than the FTC limit, 2 year carryback, 5 year carryforward.
Slide 12-9 Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 FTC Planning Firms can cross-credit between high- and low- tax rate country income. Without cross-crediting, here’s the problem: Pay tax on income in Japan branch at 50% of $100, only claim $35 FTC. Pay tax on income in Ireland branch at 10% of $100, only claim $10 FTC. Total U.S. tax on $200 x 35% = $70 - $45 FTC = $25 U.S. tax paid + $60 foreign tax paid = $85 total worldwide tax burden.
Slide Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 FTC Planning - cross credit With cross-credit, you combine all similar type foreign source income to compute limitation: FTC limit = $70 US tax X $200 foreign income / $200 worldwide income = $70. Total U.S. tax on $200 x 35% = $70 - $60 actual foreign taxes paid = $10 U.S. tax paid + $60 foreign tax paid = $70 total worldwide tax.
Slide Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 FTC for Alternative Minimum Tax FTC has an additional limit for AMT purposes: FTC cannot exceed 90% of tentative minimum tax.
Slide Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 Organizational Forms - direct taxation FSC - an ‘paper’ entity incorporated overseas that qualifies the U.S. parent for special tax exemption on export sales. Foreign branch or partnership - the U.S. corporation is fully taxed on branch or (share of) partnership income. The U.S. corporation has a direct foreign tax credit for income taxes paid by branch or partnership. The export operation, branch or partnership may be owned by any entity in the domestic group: e.g.by a U.S. headquarters corporation or by a separate domestic subsidiary created by that purpose.
Slide Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 Organization Forms - foreign subsidiary The foreign sub is NOT part of the consolidated U.S. return. The U.S. does not generally have the right to tax subsidiary income until it is paid back to the U.S. parent company (“repatriated”). When a dividend is repatriated out of after- tax earnings: the dividend is foreign source earnings the dividend is “grossed-up” (add back tax) to a pre-tax amount the associated tax generates a “deemed-paid” foreign tax credit.
Slide Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 Deemed-paid credit example USCo pays tax at 35%. UKSub pays tax at 40%. UKSub earns $100 pretax, pays tax of $40 and has after-tax earnings of $60. If UKSub pays a dividend of all the after-tax earnings of $60, the dividend is “grossed-up” to the pre-tax amount of $100. USCo has $100 of foreign source income, but may claim a FTC of $40 subject to the FTC limitation. If this is the only foreign source income, USCo would be limited to $35 of FTC.
Slide Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 Deferral of U.S. Tax Because foreign subsidiary income is not taxed in the U.S. until repatriated, large tax savings result from earning income in low-tax countries and delaying repatriation. U.S. tax is deferred until repatriation. Under U.S. GAAP (APB Opinion 23), firms can avoid recording deferred tax if they state that the earnings are “permanently reinvested.”
Slide Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 Deferral creates incentives for tax avoidance Tax deferral creates incentives to shift income artificially into low-rate countries (“tax havens”). Examples: Place cash in Bermuda subsidiary bank account - earn interest tax-free. Sell goods at low prices to Cayman Islands; resell at high prices to foreign customers - earn tax-free profit. U.S. law prevents above abuses. Subpart F income (like examples above) earned by controlled foreign corporations is taxable immediately.
Slide Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 Transfer pricing Where SubpartF rules do not apply, firms can engage in some shifting between entities through transfer prices. Examples: Pay royalties from high-tax entities to low-tax entities. Charge higher prices to high-tax entities for goods and services. Pay management fees from high-tax entities to low- tax entities. IRS has broad powers under IRC Section 482 to reallocate income to correct unrealistic prices.
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