4 Inbound Transactions U.S. Source Income Foreign U.S. Corporation OperationsU.S. InvestmentForeign Persons (§7701) * US Source IncomeNon resident aliensForeign corporationsForeign partnerships
5 U.S. Taxation of Outbound Transactions Foreign Source IncomeDomestic ForeignCorporation OperationsForeign InvestmentCredit SystemLow-tax foreign countries U.S. collects “residual” U.S. taxHigh-tax foreign countries U.S. collects no tax and credit is limited to US tax on foreign incomeMajor ExceptionsDeferral privilege (subject to Subpart F, PFIC and FPHC regimes)Foreign earned income exclusion (§ 911)
6 U.S. Taxation of Inbound Transactions U.S. Source IncomeForeign U.S.Corporation OperationsU.S. InvestmentTwo-pronged territorial systemU.S. branch operations Net basis tax on “effectively connected” incomePassive foreign investors Gross basis withholding on U.S. source non business incomeMajor exceptionsCapital gains and portfolio interest exemptionsU.S. real property interests (FIRPTA)Treaty reductions
7 Computing the Foreign Tax Credit ProcedureCompute creditable taxes (“All or Nothing”)Compute foreign tax credit limitationCredit = Lesser of creditable taxes or FTCLExcess credits: Back 2 years, forward 5 yearsComputing 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]
8 Foreign Tax Credit Limitation (§904) PurposeLimit credit to U.S. tax on foreign incomeCredit cannot exceed U.S. tax on U.S. source incomeFormulaPre-credit = Foreign source taxable incomeU.S. tax Total taxable income
9 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 $ 15Foreign tax return Taxable income $ 100 Tax rate 20% Foreign tax $ 20*
11 Excess Credit vs. Excess Limitation—Planning Issues Excess limitation position (Subpart F issues)Tax on foreign income equals foreign tax + residual US taxPlanning: Defer residual US taxExcess credit position (§ 861 planning)Tax on foreign income equals higher foreign taxPlanningReduce foreign taxesIncrease allowable credit
12 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 incomeTransfer title overseas on export salesReduce expenses apportioned to foreign source incomeCross-creditingBlend low and high tax foreign source income within the same Foreign tax credit limitation basket.
13 Cross Crediting—An Example Case 1:Domestic corporation has a branch in country XTotal income of $ 100 is attributable entirely to branch in XTax rates: U.S. = 35% and X = 50%Question: What is the amount of the excess credits?Foreign income taxes (50% of $ 100) $ 50Average foreign tax rate 50%Limitation:(a) Total taxable income $ 100(b) Pre-credit U.S. tax ($100 x 35%)(c) Foreign source taxable incomeLimitation [b x (c ÷a)]Excess credits $ 15
14 Cross Crediting—Example (Continued) Case 2:Domestic corporation also has branch in country YBranch generates $ 100 profitCountry Y tax rate is 25%Question: What is the amount of the excess credits?Foreign income taxes (50% x $ 100) + (25% x $ 100) $ 75Average foreign tax rate ( $ 75 ÷ $ 200) %Limitation:(a) Total taxable income ( $ $ 100) $ 200(b) Pre-credit U.S. tax ($ 200 x 35%)(c) Foreign source taxable incomeLimitation [b x (c ÷ a)] `Excess credits $ 5
15 §904(d) Separate Income Limitations or “Baskets”—Principal Features Passive income (usually low tax income)“mini-baskets”High withholding tax interestDividends from >10%/<50% companiesFinancial 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
16 Separate Income Limitations (or Baskets) FormulaPre-credit U.S. tax X Separate basket foreign tax inc Total taxable incomeComputationItems of foreign source income and deductionmust be allocated among the basketsForeign income taxes must be allocated among the baskets
17 Form 1118 Foreign Tax Credit Who must fileCorporations claiming FTCFile separate 1118 for each basketContentsSch A--Separate basket taxable incomeSch B--Foreign tax summary and credit computationSchs C, D, and E--Deemed paid creditSchs F, G, and H--Supporting computations
18 Foreign withholding taxes Pre-credit U.S. tax on dividend income Dividend Repatriations from a Foreign Corporation to a U.S. Parent—Tax ConsequencesForeign withholding taxesPre-credit U.S. tax on dividend incomeForeign tax credits§901 direct credit for withholding tax borne by U.S. parent (branch arrangements, not a corporation)§902 deemed paid credit for taxes paid by a foreign subsidiary (the dividend from the subsidiary is net of the withholding tax)
19 The Deemed Paid Credit—An 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)Shareholder must be a domestic corporation(does not include S corporations)Shareholder must own 10% or more of voting stockShareholder must receive dividend distribution§78 Gross-up incomeEquals amount of deemed paid creditTracing foreign taxes to dividends (see next slide)
20 Pooling Approach of §902(a) Foreign Dividend receivedDeemed = corporation’s X by shareholderPaid Credit post Foreign corporation’s foreign income undistributedtaxes E & P (excluding the current dividend)
21 FTCL basketing rules of §904(d) Dividends received from a “CFC”Controlled Foreign Corporation: More than 50% ownership requirement—follows §902 (a) pooling approachDividends received from a 10/50 corporationLook-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
22 Mechanics of CFC Look-through Rule Step Post-1986 undistributedPortion of dividend = E & P attributable to basketattributable to basket Total post –1986undistributed E & PStep 2Deemed paid Portion of dividendtaxes associated = attributable to basketwith basket Total post –1986attributable to basket
24 Deemed Paid Credit – Lower Tier Corporations (Continued) Qualification requirementsMinimum 10% direct ownership at each levelMinimum 5% indirect ownership through chainDividend Distributions up to U.S. parentNumber of qualifying tiersHistorically limited to 1st, 2nd, & 3rd tiersTRA Extended to 4th, 5th , & 6th tiers
25 Dividend Repatriations -- Planning Tax consequencesLow tax countries: Residual U.S. taxHigh tax countries: Excess creditsAnnual repatriation programCoordinate dividends to exploit cross-creditingStructure investments to minimize 10/50 company basketsUse tax treaties to minimize withholding taxes
26 Repatriating Profits – Dividends vs. Interest TaxpayerAttributeDividendInterestForeignSubsidiaryHost country deductionNoYesU.S. parentForeign withholding taxU.S. taxable income§901credit for withholding taxYes, §904 (d) appliesNo gross-up, interest is an expense§902 credit for sub’s foreign taxes
27 Earnings Stripping – An Example P’s 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 $ 0S’s foreign tax return Profit pre-interest $ 100 Interest expense 0 Taxable income $ 100 Tax rate .50 Foreign tax $ 50Facts:P, a domestic corporation, owns 100% of S, a foreign corporationS Profit before interest and taxes = $ 100Tax rates: U.S. = 35%, Foreign = 50%Assume no foreign withholding tax on interest or dividendsConclusion: Total tax = $ 50 (earnings taxed once at the higher foreign rate)
28 Earnings Stripping—Example (Continued) P’s 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 $ 35S’s foreign tax return Profit pre-interest $ 100 Interest expense 100 Taxable income $ 0 Tax rate .50 Foreign tax $ 0Facts:Earnings repatriated via interest paymentsTotal tax = $ 35 (Earnings taxed once at the U.S. rate)
29 Importance of Sourcing Rules U.S. personsTaxed on worldwide incomeForeign source income impacts foreign tax credit limitationForeign personsTaxed only on U.S. source income
30 Maximizing the Foreign Tax Credit Limitation (§904) Foreign tax Foreign sourcecredit = Pre-credit X taxable incomelimitation U.S. tax Total taxable incomeHow to increase the limitation?Gross Income Recharacterize as foreign source income for U.S. tax purposesDeductions Recharacterize as U.S. source forU.S. tax purposes
31 Overview of the Sourcing Process Goal: Determine geographic origin of incomeTwo step process similar to allocation and apportionment of state income taxesGross Income (§ 863 to § 865)Step 1: Determine statutory categoryStep 2: Apply specific category ruleDeductions (Reg )Step 1: Allocate to a related class of gross incomeStep 2: Apportion based on factual relation of deductions to gross income.
32 Sourcing Rules—The General Rules (§§861, 862) Income Sourced in the United States (§861)Interest—Interest received from the U.S. government, District of Columbia and from non-corporate U.S. residents or domestic corporationsDividends—Dividends 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 Royalties—For tangible property, the country where the property is located, for intangible property, the country where the property is used.Sale or Exchange of Real Property—Source is determined by the location of the property
33 Sourcing Rules—The General Rules (Continued) Sale of Personal Property—Factors for ConsiderationWhether the property was produced by the seller.The type of property sold (e.g. inventory of capital asset)The residence of the seller§865—Sale of Personal Property Other Than InventorySourced at the Residence of the SellerGain 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 incomeSourcing of losses depends on the nature of the property (Reg (e)(7))
34 Sourcing Rules for 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))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.
35 50-50 Method for Sourcing Sales Apply to Gross Profit, 50% to Sales and 50% to PropertyThe sales factor:Export sales where title passes abroadTotal export salesDefinition of “export sales” –Goods produced in the U.S. and sold for use, consumption or disposition abroad
36 50-50 Method: The Property Factor Average adjusted basis of foreign production assetsAverage adjusted basis of all production assetsDenominatorIncludes assets used to produce inventory in the U.S. for sale abroadProrate assets used to produce inventory sold domestically and abroadExcludes cash, receivables, inventory distribution and marketing assetsAverage basis = (Beginning of year + end of year) ÷ 2NumeratorAssets in dominator that are physically located abroadNumerator equals $0 if taxpayer has no foreign manufacturing facilities or owns foreign facilities through foreign subsidiaries.
37 Sourcing Gross Income under §861—Some Important Exceptions Interest IncomeCertain 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 incomeHigh withholding tax interest is treated as a separate basket for FTCL purposesDividendsIf 25% or more of a foreign corporation’s 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 aboveNormally passive income for FTCL purposes, but special treatment for CFC’s, 10/50 corporations, DISC’s and FSC’s..
38 §862 Income Sourced Outside the United States Not as detailed or Specific as §861If income is not U.S. source income, then it is foreign source income. §862 applies to the following:InterestDividendsCompensation for personal servicesIncome from the use or sale of propertyOther income
39 Source Rules for Deductions (Treasury Reg. 1.861-8) Step 1 Step 1: Allocation Potential Classes of Gross IncomeCompensation for servicesGross income from businessRoyaltiesGains on dealings in propertyInterestRentsDividends
40 Source Rules for Deductions (Treasury Reg. 1.861-8) Step 2 Step 2: Apportionment between U.S. and foreign source gross income Potential Apportionment BasesGross incomeGross salesUnit salesCost of goods soldProfit contributionsExpenses incurredAssets usedSalaries paidSpace usedTime spent
41 Special Apportionment Rules Interest expense—see next slideResearch 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)
42 Special Apportionment Rules--Continued Stewardship expenses—If 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 property—The 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)
43 Source Rules for Interest Expense Fungibility principleAllocate interest to all gross income even if borrowing relates to specific assetApportionment baseTwo methods available—fair market value or tax book value §864 (e)(2)Affiliated groupsTreated as a single corporation for purposes of apportioning interest expense
44 Worldwide Effective Tax Rate—Why It is Important Impact reported earningsImpacts cash flowImpacts evaluation of tax director
45 Examples of Impact of Foreign Operations on Effective Tax Rates Caterpillar U.S. statutory rate %FSC benefit (3.2%)Other ` (1.2%)` Effective tax rate %Exxon/Mobil U.S. statutory rate %Operations in high tax countries 15.5% Other (6.2%)Effective tax rate 44.3%Pfizer U.S. statutory rate %Operations in low tax countries (5.5%)Operations in Puerto Rico (2.2%)Other (2.5%)Effective tax rate 24.8%
46 Planning for Foreign Operations by a U.S. Domestic Corporation Goal: To minimize worldwide effective tax rate on foreign source incomeU.S. tax on foreign incomeDeferralForeign sales corporations and extraterritorial income exclusionForeign taxesReducing foreign taxesMaximizing allowable U.S. credit
48 Taking Advantage of Deferral--Continued Deferral = 25% residual U.S. taxFinancial reporting: Can treat as permanent difference that increases current earnings (APB 23)Other examples of low tax countries: Singapore and Hong KongRestrictions on deferralArm’s length transfer priceSubpart F§367 outbound toll charge
49 Operating in High Tax Foreign Countries – Example
50 Operating in High Foreign Tax Countries--Continued Problem: Excess foreign tax creditsOther examples of high tax countries: Canada and GermanyPlanning:Increase allowable creditsReduce foreign taxes
51 Contract Manufacturing and Commissionaires—An Example
52 Example (continued)--Commissionaire ActivitiesActs as agent for undisclosed principal, Worldco(contract is between commissionaire and customer)Worldco retains title until it passes to customerWorldco finances receivables and bears credit riskMarketing intangibles remain with WorldcoTax consequencesCommissionaire’s income reduced commensurate with reduced responsibilities and risksCommissionaire’s income determined using cost-plus approachCommissionaire does not create a permanent establishment for Worldco
53 Example (continued)—Contract Manufacturer ActivitiesProcesses component materials into finished products under contract with WorldcoWorldco retains title to inventoryProfit and loss risk remains with WorldcoManufacturing intangibles remain with WorldcoTax consequencesContract manufacturer’s income reduced commensurate with reduced responsibilities and risksContract manufacturer’s income determined using cost-plus approachContract manufacturer does not create a permanent establishment for Worldco
54 Foreign Tax Reduction Planning—Holding Companies (Example) AssumeU.S. parent corporationR.S.A. subsidiaryDutch holding companyR.S.A. makes dividend distribution to U.S. parentWithout the Dutch Holding CompanyThe R.S.A. dividend subject to 25% withholding tax.Dutch Holding CompanyThe R.S.A. dividend subject to 5% withholding tax.The Dutch holding company dividend is subject to an additional 5% withholding tax.
55 Foreign Tax Reduction Planning—Earnings Stripping Debt financing for foreign subsidiariesInterest expense deduction in host countryPossible reduction in foreign withholding taxesPossible increase in foreign tax credit limitation(subject to CFC netting rule)Transfer pricing and technology chargesInventory salesTechnology chargesManagement fees
56 Foreign Tax Reduction Planning—Incentives in Local Tax Laws ExamplesIreland—10% rate for manufacturingSingapore—Tax holidays for high-tech companiesPuerto Rico—2% to 7% rate for manufacturingBelgium—Special tax breaks for coordination, service and distribution centers
57 Hybrid Entities Classification of Foreign Entity A U.S. tax shelter? Foreign tax purposes, a corporationU.S. tax purposes, a partnership or branchA U.S. tax shelter?
58 Reg. 301.7701—The Check-the-Box Regulations Effective date: January 1, 1997Goal: Simplify entity classificationNew approach:“Per se” corporations (e.g. U.K plc, German AG, French SA, Dutch NV) classified as corporationsFor all other entities, taxpayers chooses classification via “check-the-box” procedureBenefits: Enhances ability to use branches and partnerships in international tax planning
59 Tax Benefits of a Hybrid Entity Avoids 10/50 company basket problemsAllows flow-through of foreign losses, subject to dual consolidated loss limitationsAllows flow-through of foreign tax credits to S corporation or partnership shareholders, a direct §901 foreign tax creditSolves §902 multiple tier problemsAvoids Subpart F through the use of “super” holding companies and interest transfers from high tax country hybrid to a low tax country finance country hybridWhat is the next frontier of effective tax planning?
61 What is Transfer Pricing--Continued 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 subsidiaryTransfer price of $ 85 would allocate entire profit to U.S. parentTransfer price between $ 60 and $ 85 splits the profit between the U.S. parent and the foreign subsidiary.
62 § 482Goal: Clearly reflect income of affiliated corporations engaged in inter-company transactions.Standard: Arm’s-length price (or market value) standard for evaluating transfer pricesPractical 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.
63 Principal Factors for Assessing Comparability of Controlled and Uncontrolled Transactions—RegFunctions performed by the parties involvedContractual terms governing transactionRisks assumed by each partyEconomic or market conditions in which parties conduct businessNature of property or services transferred in transaction
65 Transfer of Intangibles (Reg. 1.482-4)--Continued ProblemNo comparables due to uniqueness of intangiblesCongressional responseCommensurate with income requirementPricing methodsComparable uncontrolled transaction methodComparable profits methodProfit split method
66 Comparable Profits Method (Reg. 1.482-5) Determine which affiliate will be the tested party.Obtain data regarding comparable uncontrolled parties.Choose profit level indicator, such as operating profit/sales or operating profit/operating assets.Construct arm’s length range of comparable profits for tested partyMake adjustment if reported profit lies outside arm’s length range.
67 §662(e) Transfer Pricing Penalties RationalePromote more voluntary compliance with arm’s length standardPromote better documentation of transfer pricing policies20% penalty applies if:Transfer price 200% (or 50%) of arm’s length price (“transactional penalty”), orNet §482 adjustment > either $ 5 million or 10% of gross receipts (“net adjustment penalty”)
68 §662(e) Transfer Pricing Penalties--Continued 40% penalty applies if:Transfer price 400% (or 25%) of arm’s length price, orNet §482 adjustment > either $ 20 million or 20% of gross receiptsReasonable cause exceptionTo avoid net adjustment penalty, taxpayer must have created “contemporaneous” documentationDHL Corporation, TC MemoIRS’s imposition of §6662 penalty upheld in court
69 How Should Taxpayers Respond? Develop documentation that supports methodology and resultsPrincipal documents (§ )Nature of businessEconomic and legal environmentOrganizational structureControlled transactionsPricing methods selected, rationaleComparables usedEconomic analysis and projectionsAssess risk of transfer pricing adjustmentDollar magnitude of inter-company transactionsPercentage of worldwide profits attributed to low-tax foreign subsidiariesConsider transfer pricing study or Advance Pricing Arrangement
70 Review—U.S. Taxation of Foreign Subsidiaries Tax JurisdictionExcluded from U.S. consolidated return, can [by election] include Canadian and Mexican corporations in the groupTaxed only on U.S. source incomeProfit ReparationsU.S. parent can not claim the dividend received deductionU.S. parent can claim a §902 creditFTCL basketing rules: 10/50 company or CFC look-through ruleTransfer PricingMust use arm’s-length prices.
71 Shifting Income to a Foreign Base Company—An Example
72 Anti-Deferral Provisions ConceptDeny deferral of “tainted” foreign earningsSimultaneously allow deferral for active foreign business profitsSpecific regimesForeign Personal Holding Companies (enacted in 1937, “pocket book overseas”)Subpart F (enacted in 1962)Passive Foreign Investment Company (enacted in 1986), discourages investment in foreign mutual fund companies
73 Subpart F (§§951-964), Controlled Foreign Corporations CFC definedU.S. shareholders own >50% of stock, by vote or valueU.S. shareholder is a U.S. person that owns 10% or more of stockSubpart F inclusion (deemed dividend)Subpart F incomeInvestments in U.S. property
74 Subpart F Income (§§ )FTCL basket is determined by the type of income earned by the subsidiaryForeign base company sales incomeIncome from the sale of goodsGoods are purchased from or sold to a related personCFC neither manufactures the product or sells it for sells it for use in CFC’s 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 incomeFees for services performed outside CFC’s country of incorporation for a related person.Insurance incomeIncome from insuring risks outside the CFC’s country of incorporation (i.e. lower risks)Foreign personal holding incomePassive investment income such as dividends, interest, rents, royalties and capital gainsForeign base company shipping incomeForeign base company oil-related income
75 Taxation of U.S. Shareholders U.S. Shareholders Receive a “Deemed Dividend” from the Controlled Foreign CorporationYear in which CFC has Subpart F IncomeU.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 incomeActual dividend distributions in subsequent years (§959)Traced first to CFC’s “previously taxed income” (PTI)Receipt of PTI is a tax- free return of capital
76 Earnings Invested in U. S Earnings Invested in U.S. Property by the Controlled Foreign Corporation (§956)Concept: Constructive dividend of active foreign business profitsTreatment: Current inclusion under Subpart FTransactions triggering §956 inclusionsCFC makes loan to U.S. shareholders (includes guarantees)CFC purchases stock issued by U.S. shareholdersCFC purchases tangible property located in U.S.CFC purchases right to use intangible property is U.S.
77 Form 5471 Information Return of a U.S. Person with Respect to a CFC Who must fileShareholder of CFCContentsSch. A – Stock of CFCSch. B – U.S. shareholdersSch. C and F – Financial statementsSch E, H and J – Foreign taxes and E&PSch. I – Subpart F incomeSch M – Inter-company transactionsSch. O – Changes in stock ownership$ 10,000 penalty for failure to fileTRA of 1997 added similar reporting requirements for foreign partnerships controlled by U.S. persons
78 Foreign Personal Holding Company (§§551-558) Concept: Incorporated pocketbook of wealthy U.S. citizensDefinition of FPHC5 or fewer U.S. citizens own 50% or more of stock60% or more of gross income is FPHC incomeDeemed Dividend = Undistributed FPHC income
79 Passive Foreign Investment Company (§§1291-1298) PFIC defined:75% or more of gross income is passive investment income or50% or more of assets produce passive incomeTaxation of U.S. shareholdersQualified Electing Fund electionCurrent taxation orExcess distribution: Pay deferred tax + interest
80 Review—Subchapter C Non-recognition Provisions ConceptTax-free treatment of changes in legal form, but not the underlying substance, of an investmentAny appreciation not taxed currently is preserved for taxation in the future through carryover basisNon-recognition TransactionsIncorporations (§351): Transfers of appreciated property to a controlled corporationSubsidiary liquidations (§332): Transfer of appreciated property to parent corporation in complete liquidationReorganizations (§368 (a)(1)(A) and (a)(1)(D): Acquisitive (e.g., merger) and divisive (e.g., spin-off)
81 Illustration of Tax Avoidance Opportunities Created by Outbound Transfers to Foreign Corporations
82 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 parent’s U.S. income tax return.Impact of §367(a): Recast tax-free transfers as taxable salesException: Assets used in active foreign business (§367(a)(3)(A))Exception does not apply toInventory, 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
83 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 RoyaltyCommensurate with income requirement Yes YesForeign source income Yes YesForeign tax deduction No YesForeign withholding taxes No Yes(treaties, however, often provide exemption)
84 Illustration of Tax Avoidance Opportunities Created by Inbound Liquidation of CFC FactsCFC distributes its accumulated E & P to USP in liquidationU.S. tax consequences, ignoring §367CFC’s earnings were not taxed currently (deferral privilege)USP’s receipt of the distribution is tax free under §332Any residual U.S. tax is permanently avoided
85 Deemed Dividend Regime of §367(b) As a result of the CFC liquidation the U.S.Parentwill pay an inbound toll charge on its U.S. tax return.Bad news:USP must include in income the lesser of(a) Dividend = CFC’s accumulated E & P(b) Capital gain = MV of distribution – USP’s basis in stockGood news:USP can obtain §902 credit with respect to any dividend income
86 §367 Summary—Important to Consider the Source of the Property and Where It Ends Up Code SectionSource/EndOutcome§367 (a)Start in the U.S. and ends overseasBad, unless exception§367 (b)All inbound transactionsGood, unless bad§367 (d)U.S. to Offshore(Intangibles)Bad
87 Other Non-recognition Transactions Subject to a Toll Charge U.S. corporation transfers appreciatedproperty to a foreign entity.Outbound transfers to non-corporate entitiesTRA 1997 added §721(c): Transfers to partnerships with foreign partnersAlso added §684: Transfers to foreign estates and trustsExpatriating liquidation of U.S. subsidiary into foreign parentOther inbound and foreign-to-foreign transfers involving CFC’s
88 Overview of Inbound Transactions A foreign corporation invests in U.S. assetsand receives U.S. source income.General RulesWithholding 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 RulesTreaty exemptions and reductions (e.g. UK 5% dividends, 0% interest and royaltiesAnti-earnings stripping rules (§163(j))U.S. real property interests (§897)Branch profits tax (§884)
89 U.S. Taxation of Non-Business Income General RulesBase = Gross amount of U.S. source incomeStatutory rate = 30%Collection via withholding by U.S. payerExceptionsCapital gainsPortfolio interest income (10%+ shareholders excluded)U.S. real property interestTreaty withholding ratesW8 BEN available for non-resident aliens
90 Repatriating Profits from Domestic Subsidiaries Goal: to minimize U.S. taxes (subsidiary-level and shareholder-level, and foreign taxes)From the U.S. subsidiary perspectiveThe issue is whether the remittance to the foreign parent corporation creates a U.S. tax deductionFrom the foreign parent perspectiveWhat is the U.S. withholding tax rate on the remittance?Are foreign taxes owed on the remittance?
91 §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” expenseDefinition 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
92 Anti-Earnings Stripping Provisions (Continued) Disallowed interest expense deductions are limited to the amount of excess interestDefinition of “excess interest”Net interest expense – 50% (adjusted taxable income)Net interest expense = interest expense – interest incomeAdjusted taxable income = Taxable income+ Net interest expense+ NOL carryovers+ Depreciation expense+/- Changes in receivables and payables“Excess interest” is a cash flow conceptIndefinite carry-forward of disallowed interest expense deductions
93 Planning for Section 163 (j) Remove foreign parent’s guaranteeReduce U.S. subsidiary’s debt-to-equity ratio below 1.5 to 1Increase U.S. subsidiary’s “adjusted taxable income” without increasing taxable incomeU.S. subsidiary should buy assets rather than leasing them.
94 Form 5472: Information Return of a Foreign-Owned U.S. Corporation Who must file25% foreign-owned domestic corporationForeign corporation engaged in U.S. trade or businessContents25% foreign subsidiariesOther related partiesTransactions with foreign related partiesRecord maintenance requirements$ 10,000 annual penalty
95 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 buildingsMines, wells and other natural depositsGrowing crops and timberPersonal property “associated with” use of real property such as fences and moveable equipment
96 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 corporationsMarket value of U.S. real property holdings 50% of market value of all real property and business interestsPurchasers of U.S. real property interestsObligation to withhold 10% U.S. tax on amount realized by foreign seller.
97 U.S. Taxation of Inbound Transactions A foreign corporation receives ECI and/orFDAPTwo-pronged system for taxing foreign personsPassive foreign investors: Gross basis withholding taxU.S. branch operations: Net basis on ECIFocus here is on U.S. branch operations
98 Foreign Corporation Engaged in a U.S. Trade or Business NexusPer 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 incomeSelected types of foreign source business incomeSelected types of U.S. source non-business incomeLook back rules (10 years under §864(c)(7)Tax rate schedule: same as domestic corporation
99 §884—The Branch Profits Tax—Rationale Goal: Mimic U.S. withholding tax on dividends paid by U.S. subsidiaries (Comparison of # 1 with # 2)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.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.
100 Computing the Branch Profits Tax Need formula for estimating dividend equivalent amountUnder §884 (b)Effectively connected E & P for the year+ 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 amountTax rate = 30% statutory rate subject to treaty reductionsSome Treaties eliminate the amount
101 Branch Profits Tax– An Example (Year 1) Treaty rate on dividends (controlling shareholder) = 5 %Effectively connected E & P = $ 100U.S. net equity: $1,000 at beginning of year$1,100 at end of yearBranch profits tax calculation:Effectively connected E & P $ 100Increase in U.S. net equity:Beginning of year $ 1,100End of year ,100 (100)Dividend equivalent amount $ 0x 5%Branch profits tax $ 0
102 Branch Profits Tax: An Example (Year 2) Treaty rate on dividends (controlling shareholder) = 5 %Effectively connected E & P = $ 100U.S. net equity: $1,000 at beginning of year$1,100 at end of yearBranch profits tax calculation:Effectively connected E & P $ 0Decrease in U.S. net equity:Beginning of year $ 1,100End of year ,Dividend equivalent amount $ 40x 5%Branch profits tax $ 2
103 §884 (f)—Branch Interest Withholding Tax What is it?30% withholding tax on “interest payments”Tax imposed on foreign payee, not the U.S. branchCreates tax parity between U.S. tax imposed on interest payments made by U.S. branches and U.S. subsidiariesComputation of tax:Reg defined “interest payment”Statutory exemptions (e.g. portfolio interest exemption) and reduced withholding rates apply
104 §884(f)--An Additional Provision, The Excess Interest Tax What is it?30% tax on U.S. branch’s excess interestTax is imposed on U.S. branch, not the recipient of the interest paymentRecapture provision designed to create symmetry between interest deductions and related interest income inclusionsComputation of tax:Excess interest = Interest expense deducted in computing “Effectively Connected Income” (per § )minus“Interest payments” subject to branch interest withholding tax [See Precedingslide]Reduced treaty withholding rates apply