1 Chapter 16: U.S. Taxation of Foreign-Related Transactions

2 U.S. TAX OF FOREIGN- RELATED TRANSACTIONS nJurisdiction to tax nTaxation of U.S. citizens & residents nTaxation of nonresidents nU.S. taxation of foreign activity

3 Jurisdiction to Tax nTaxpayer’s country of citizenship nTaxpayer’s country of residence nType of income earned nLocation where the income is earned

4 Taxation of U.S. Citizens and Residents nU.S. citizens and resident aliens taxed on worldwide income nIncome earned in foreign countries or U.S. possessions receives special treatment nForeign tax credit nForeign earned exclusion

5 Foreign Tax Credit (FTC) (1 of 3) nFTC permits U.S. citizens and residents to avoid double taxation nDirectly reduces U.S. tax liability nFTC limited to lesser of Foreign tax actually paid OR foreign taxable income_ U.S. tax worldwide taxable income x liability

6 Foreign Tax Credit (FTC) (2 of 3) nSource of income rules on p. C16-6 –Used to determine numerator of FTC formula nFTC deducted after nonrefundable credits for 2004 and later years

7 Foreign Tax Credit (FTC) (3 of 3) nUnused FTC carried back two years and forward five years on a FIFO basis to a year where taxpayer has an excess credit limitation nSpecial FTC limitation –Ten separate baskets of income »Foreign tax credit calculated for each basket of income »See page C16-7 for partial list of baskets

8 Foreign Earned Income Exclusion (FEI) (1 of 5) nFEI available to U.S. citizens and resident aliens working abroad nEligibility –Bona fide resident test »Resident of foreign country uninterrupted for entire tax year and maintain tax home in foreign country

9 Foreign Earned Income Exclusion (FEI) (2 of 5) nEligibility (continued) –Physical presence test »Taxpayer must be physically present in a foreign country for 330 full days during a 12-month period, AND »Maintain a tax home in a foreign country during that period

10 Foreign Earned Income Exclusion (FEI) (3 of 5) nForeign earned income –Wages, salaries, & fees as compensation for personal services actually rendered nAmount of exclusion –Lesser of »$80,000, OR »Foreign earned income for current year, OR »$ ($80k/366 days in 2004) x no. of qualifying days in current yr

11 Foreign Earned Income Exclusion (FEI) (4 of 5) nAdditional exclusion for taxable housing allowance –Limitation lesser of »Actual housing amount included in income,OR »$11,581 (.16 x Step1 GS-14 rate) x (qualifying days/366) –Housing costs incurred in excess of $11,581 are a for AGI deduction

12 Foreign Earned Income Exclusion (FEI) (5 of 5) nHousing allowance exclusion (continued) –Housing allowance exclusion reduces amount eligible for FEI nFTC and FEI are mutually exclusive –Claim either the FTC or the FEI on foreign earned income, but not both

13 Taxation of Nonresident Aliens (1 of 5) nResident aliens are taxed same as U.S. citizens nNonresident aliens generally taxed only on U.S. source income nTaxpayer is a resident alien if they meet one of the two tests

14 Taxation of Nonresident Aliens (2 of 5) nResident alien tests –Green-card test »Permanent resident w/ “green card” visa –Physical presence test »Present  31 days during current calendar year AND present  183 weighted average days during a three year period Current year: 1 day counted as 1 day Prior year: 1 day counted as 1/3 day 2nd prior year: 1 day counted as 1/6 day

15 Taxation of Nonresident Aliens (3 of 5) nMost U.S. source passive or investment income is taxed at 30% –30% applied to gross amount –U.S. payer must withhold tax »U.S. payer responsible for tax if not withheld –Tax rate often reduced by tax treaties

16 Taxation of Nonresident Aliens (4 of 5) nIncome exempt from U.S. taxation –Non-USToB capital gains if individual physically present < 183 days during year –Non-USToB interest from banks or other financial institutions not taxed –Portfolio interest –Income from casual sale of personal property

17 Taxation of Nonresident Aliens (5 of 5) nIndividuals must itemize deductions –Cannot claim standard deduction nNormal deductions apply for items “effectively connected” to a USToB –Gains from real property considered “effected connected” to a USToB nTax treaties often reduce or eliminate U.S. for many types of income

18 Taxation of U.S. Business Operating Abroad nDomestic corporations nForeign corporations nDeemed paid foreign tax credit nControlled foreign corporations n§482 rules and tax avoidance nForeign Sales Corporations

19 Domestic Corporations nDomestic subsidiary corporations –Can file consolidated return w/parent –Parent protected from foreign creditors of subsidiary nForeign branches –Income and losses taxed currently –Eligible for direct FTC (described earlier)

20 Foreign Corporations (1 of 2) nIf domestic corp owns  10% of foreign corp, domestic corp eligible for “deemed paid credit” for dividends received from foreign corp

21 Foreign Corporations (2 of 2) n  10% domestic corp owner can also claim dividends received deduction nU.S. tax on foreign sub’s income deferred until dividends received

22 Deemed Paid Foreign Tax Credit nDeemed paid credit calculation Div paid to domestic corp (from post 1986 undist earnings All post 1986 undistributed earnings X Creditable taxes paid or accrued by foreign corp (post 1986) = Deemed paid foreign tax credit

23 Controlled Foreign Corporations (CFC) (1 of 3) Typical tax-avoidance scenario of a CFC U.S. Manufacturing Corporation (Chicago) Foreign Sales Subsidiary (Island Corporation) Foreign Purchasers of U.S. Manufacturer’s Products Billing of tax haven sales subsidiary by U.S. manufacturer Billing of foreign purchasers by tax haven sales subsidiary Physical flow of goods

24 Controlled Foreign Corporations (CFC) (2 of 3) nCFC definition –> 50% of foreign corp stock owned by U.S. shareholders »U.S. shareholder defined as owning  10% of stock nSome income forms (Subpart F income) of the CFC are taxed in the year in which they are earned.

25 Controlled Foreign Corporations (CFC) (3 of 3) nTax-deferred earnings can be taxed under Subpart F when invested in U.S. property. nPreviously taxed income is distributed tax-free. nSpecial rules apply to the sale or exchange of CFC stock.

26 §482 Rules & Tax Avoidance (1 of 3) nTax avoidance opportunity high for domestic parent and 100% owned subsidiary (see slide #23) –U.S. parent sells goods/services at less than FMV to 100% foreign sub, OR –Foreign sub pays less than FMV for use of U.S. parent’s intangibles (e.g., patents)

27 §482 Rules & Tax Avoidance (2 of 3) n§482 authorizes IRS to distribute, apportion, or allocate gross income, deductions, credits or allowances between or among controlled entities

28 §482 Rules & Tax Avoidance (3 of 3) n§482 Regs hold that transaction of tangible property between entities must meet arm’s-length standard –Consistent w/ transactions between uncontrolled entities »Comparable transaction under comparable circumstances

29 Foreign Sales Corporations (FSC) (1 of 4) nFSC is a special export entity –Must meet certain mandated administrative and economic activity requirements. nPart or all of FSC’s foreign trade income exempt from U.S. taxation –Exempt amount based on transfer pricing method used. »May use other-than-arm’s-length pricing.

30 Foreign Sales Corporations (FSC) (2 of 4) nDividend distributions may be eligible for a 100% dividends- received deduction. nForeign tax credit also available for taxes withheld on dividends. nFSC status restricted to foreign corps having made FSC election before 10/1/2000.

31 Foreign Sales Corporations (FSC) (3 of 4) nIn 2000, the World Trade Organization declared that FSCs are illegal export subsidies

32 Foreign Sales Corporations (FSC) (4 of 4) nIn 2001, U.S. replaced FSCs with extraterritorial income rules –In 2002, WTO declared extraterritorial income rules an illegal export subsidy –Congress proposed to repeal extraterritorial income rules and replace with other economic incentives

33 Comments or questions about PowerPoint Slides? Contact Dr. Richard Newmark at University of Northern Colorado’s Kenneth W. Monfort College of Business