Introduction to International Taxation

Introduction to International Taxation
US International Tax Framework and Structuring Foreign Operations PwC

Module Objectives Upon completion of this module, participants will (be able to): Describe the basic principles of US taxation of US multinationals with foreign activities and foreign multinationals with US activities Recognize that the form of doing business abroad is likely to change over time as a US company expands its foreign operations Discuss the general tax implications of operating abroad through exporting, licensing, branches, partnerships, or foreign subsidiaries Explain the use of the "check-the-box" regulations in classifying entities Identify the conditions that create a foreign income tax exposure Recognize that several foreign currency rules apply to income from exporting or operating branches Describe the implications of transfer pricing rules Identify the general US tax implications of cross-border M&A transactions

U.S. International Tax Framework
The US uses a “hybrid” taxing system related to cross-border income/taxpayers Worldwide Income/Tax Credit System Applicable to US persons Worldwide income subject to tax Potential double taxation primarily mitigated with a foreign tax credit Territorial system Applicable to non-US persons Only certain income earned from US activities is subject to US taxation Use the next few slides to introduce the basic framework for the US taxation of cross border transactions. Emphasize the different methods used for US persons versus foreign persons.

U.S. International Tax Framework (cont’d)
Type of Person U.S. Foreign US Source Income Foreign Source Income US Source Income Foreign Source Income Potentially Taxed in U.S. Taxed in U.S. Taxed in both U.S. and foreign jurisdiction Generally taxed only in foreign jurisdiction This slide helps illustrate the different consequences of US taxation depending on type of taxpayer and type of income. Introduce the concepts of “outbound” and “inbound” taxation as used in ITS practice. Note that this simple slide does NOT illustrate all the potential exceptions to US or foreign taxation that might occur. Note that this slide simply sets up the “big picture” framework. “Inbound” Foreign Tax Credit allowed “Outbound”

Taxation of Foreign Persons with U.S. Connected Income
U.S. source “investment” income Taxed on gross income with no deductions permitted Taxed at a 30% rate via withholding unless reduced by a tax treaty U.S. source trade or business income Deductions are permitted Taxed at progressive rates Potential branch level taxes The next two slides briefly introduce the methods used to tax foreign persons on income from US activities. Point out that this is the general framework and several exceptions and special rules will apply. Inbound taxation is addressed in more detail on the last day of the course.

Taxation of Foreign Persons with US Connected Income: “Inbound” Taxation
US source investment income US withholding tax Local country income tax US source income from business operations US income tax US branch level taxes US withholding taxes Local country income tax ForCo This slide illustrates the basic tax consequences for a foreign person earning income from US activities. Topic is addressed in more detail later in the course.

Taxation of U.S. Persons with Foreign Income: “Outbound” Taxation
Foreign source investment income US income tax Local country withholding tax USCo This slide illustrates that a domestic company typically earns two types of foreign income (both types are subject to US taxation because the US person is taxed on worldwide income): “passive” income from investment activities abroad (generally subject only to a foreign country withholding tax because the US company has no taxable presence in the foreign country). “active” business income from conducting a trade or business in the foreign jurisdiction. Here the US person is typically subject to a foreign income tax in the foreign jurisdiction. In addition, certain payments back to the US company may be subject to withholding (e.g., dividend or royalty payments). Foreign source income from business operations US income tax Local country income tax Local country withholding tax

US Outbound Example $1,000 US Source Net Income
Corporation (35% tax) $600 Foreign Source Net Income (subject to tax in both the US and foreign jurisdiction) Foreign Branch (30% tax) The next few slides illustrate the implications of the worldwide tax/credit system for US taxpayers. The examples illustrate the implications of double taxation with no mitigation, partial mitigation (deduction for foreign taxes), and full mitigation (fully used FTC). Note that for many of the simple examples, foreign currency issues are ignored, with all currency amounts stated in U.S. dollars. US Corporate Tax Return – Form 1120

US Taxation – Assuming No FTC or Deduction for Foreign Taxes
US Tax Return Foreign Country Tax Return US Source Income Foreign Source Income Taxable Income US Income Tax $1,000 600 $1,600 x .35 $ 560 Foreign Income Tax $600 x .30 $180 US Tax Foreign Tax Worldwide Tax Worldwide ETR $ $740 46.25% [$740/$1,600] This slide illustrates the result with no double tax mitigation.

US Taxation – With Deduction for Foreign Taxes
US Tax Return Foreign Country Tax Return US Source Income Foreign Source Income Deduction for Foreign Tax Taxable Income US Income Tax $1,000 600 -180 $1,420 x .35 $ 497 Foreign Income Tax $600 x .30 $180 US Tax Foreign Tax Worldwide Tax Worldwide ETR $ $677 42.30% [$677/$1,600] This slide illustrates the effect of deducting the foreign tax.

Foreign Country Tax Return
US Taxation – With FTC US Tax Return Foreign Country Tax Return US Source Income Foreign Source Income Taxable Income US Income Tax (before FTC) Less FTC US Income Tax (after FTC) $1,000 600 $1,600 x .35 $ 560 -180 $380 Foreign Income Tax $600 x .30 $180 US Tax Foreign Tax Worldwide Tax Worldwide ETR $ $560 35% [$560/$1,600] This slide illustrates the benefit of fully crediting the foreign income tax. Point out that the ability to use the FTC is a key issue for US multinationals. The FTC module will address the FTC rules in much greater detail.

Structuring Foreign Operations
This section simply emphasizes what sorts of things can create an exposure to a foreign income tax. The treaty concept of PE is briefly introduced as well. Later in the course an entire module covers tax treaties in more detail. Structuring Foreign Operations

Tax Issues in Structuring Foreign Operations
Form of doing business (method/entity choice) Foreign income tax exposure Activities in foreign jurisdiction that give rise to an income tax exposure Permanent establishment (PE) under an income tax treaty Foreign currency implications from foreign operations US and foreign transfer pricing policy and compliance requirements US income tax implications of creating foreign entities, transferring assets outside the US, and other cross-border transactions Use this slide to introduce the key issues US multinationals deal with in managing their international operations and making decisions about how to “go global” in an efficient manner. The remainder of this module addresses these key issues in more detail.

Structuring of Foreign Operations: Overall Objectives
Global Tax Optimization (subject to business goals) Where do we want to put our profit? Profit Drivers: Assets Functions Risk Which drivers attract the most profit? Point out that the profit drivers that attract the most profit are likely to differ depending on the industry/context. For example, in the case of a bank, capital may be the major profit driver. For a high-tech company know-how or intangibles attract the most profit. The main point to be made with this slide is that companies must place their profit drivers within entities in a manner that allows for optimization of its global tax burden. That is, profit drivers that attract high profits should be in low-tax jurisdictions, all else equal.

Going Global Over Time Potential Deferral Current U.S. Taxation Time
Domestic Operation Only Export License to Foreign Person Foreign Branch or Partnership Separate Foreign Entity Point out that companies rarely begin their foreign operations with a “full blown” foreign presence (e.g., manufacturing operations, sales divisions, R&D, etc.). Rather, a domestic company is more likely to first explore the foreign market through export sales (“testing the market”). If a customer base exists, the US company may expand their foreign operations by licensing their technology or product to independent third parties in the foreign countries or may go straight to a local business presence, establishing a sales office, distribution center, or manufacturing operations. This step will create a foreign branch (or partnership if the US company chooses to partner with a local company). At this point, all the foreign income remains taxable in the United States because all the income is earned directly by a US person. The US company may or may not have a foreign tax exposure depending on the level of activity within the foreign country, the type of income earned, and the foreign country tax law. The existence of a tax treaty is also a key issue at this point (as discussed later). Once the US company establishes a separate foreign corporation, the potential for deferral from US tax exists. As discussed later in the course, Subpart F and other anti-deferral regimes may restrict this deferral. Potential Deferral Current U.S. Taxation

Forms of Doing Business and the U.S. Tax Effects
Type of Entity US Taxation? Timing of US Taxation Export Full Current inclusion License Branch Partnership Foreign Corporation Only upon repatriation or deemed inclusion Deferral (but Subpart F, 956 income, and other provisions may require current inclusion) Note that type of entity in this illustration includes hybrid entity treated as such under US principles (e.g., a foreign corporation treated as disregarded (branch) under the check the box rules is branch. The next few slides summarize the basic implications of operating abroad using different approaches. Afterwards, the check-the-box rules and basic currency rules are addressed in more detail.

Criteria for Selection of Method/Entity
Method/Entity choice is often the result of a "growth process“ as a business becomes more global in scope Key factors: business objectives benefit from partnering with foreign 3rd parties need to protect intangible property or know-how projection of operating results expected repatriation demands type of income to be earned exposure to foreign income tax availability of treaty benefits

Exposure to Foreign Income Tax
This section simply emphasizes what sorts of things can create an exposure to a foreign income tax. The treaty concept of PE is briefly introduced as well. Later in the course an entire module covers tax treaties in more detail. Exposure to Foreign Income Tax

Exposure to Foreign Income Tax
US firms generally face exposure to foreign income taxes when their activities in the foreign jurisdiction rise to the level of a “trade or business” within that jurisdiction This concept is similar to “nexus” in a multi-state context When income tax treaties exist, the generic “trade or business” concept is replaced with the more formal definition of a permanent establishment

Permanent Establishment
The Permanent Establishment (PE) tax treaty concept is similar to “trade or business” but allows more activities without giving rise to an income tax exposure in the jurisdiction A PE generally is created by a fixed place of business Fixed place of business includes: place of management branch office factory workshop

Permanent Establishment (cont’d)
Permanent Establishment typically excludes: Facility for maintenance of goods solely for storage, display or delivery Maintenance of a fixed place of business solely for carrying on activities that are preparatory or auxiliary in nature Temporary construction project Engagement of broker or agent of independent status Subsidiary of parent unless parent carries on business itself

Form of Doing Business Abroad

Going Global - Exporting
No separate entity required No deferral Foreign tax exposure Customs/VAT/GST taxes Not available for use as FTCs Typically no foreign income tax exposure if only exporting activity Income tax treaty (if applicable) provides more certainty under the PE article than reliance on local country law to determine income tax exposure Potential foreign currency implications - §988 Use this slide to briefly summarize the implications of exporting for US taxpayers. Later slides cover the PE article of tax treaties, and the basic foreign currency issues.

Going Global - Licensing
No separate entity required No deferral Foreign tax exposure Foreign withholding taxes on royalties Income tax treaties (when applicable) reduce withholding rates (often to zero) Withholding taxes available as FTCs on US tax return Typically no foreign income tax exposure (other than withholding taxes) for US company itself if only licensing in the jurisdiction Potential foreign currency implications - §988 Use this slide to briefly summarize the implications of licensing for US taxpayers. Later slides cover the basic foreign currency issues. A later module deals with tax treaties in general.

Going Global - Branch No separate entity required
Note applicability of “check-the-box” rules in determining whether a foreign entity is a branch or separate corporation No deferral / Flow through of foreign losses (but see DCL issue discussed in course text material) Foreign tax exposure Typically the US corporation is liable for foreign income taxes on net profits associated with foreign branch Typically the branch activities will constitute a PE under any applicable income tax treaty Foreign income taxes available as FTCs on US return Foreign jurisdiction transfer pricing issues in determining foreign net profit Potential foreign currency implications - §987 Use this slide to briefly summarize the implications of operating a foreign branch for US taxpayers. Later slides cover the basic foreign currency issues and check the box. A later module deals with tax treaties in general.

Going Global - Partnership
Formal or informal partnership agreement Note applicability of “check-the-box” rules in determining whether a foreign entity is a partnership or separate corporation No deferral Foreign tax exposure Typically the US person is liable for foreign income taxes on net profits associated with foreign partnership Typically the partnership activities will constitute a PE to the US partner under any applicable income tax treaty Foreign income taxes available as FTCs on US return Foreign jurisdiction transfer pricing issues in determining foreign net profit Potential foreign currency implications - §§987 & 988 Use this slide to briefly summarize the implications of operating through a foreign partnership for US taxpayers. Later slides cover the basic foreign currency issues and check the box. A later module deals with tax treaties in general.

Going Global – Foreign Subsidiary
Separate legal entity created Note applicability of “check-the-box” rules in determining whether a foreign entity is a branch/partnership or separate corporation Potential US tax implications in creating foreign subsidiary - §367 No current US tax (deferral) absent Subpart F, §956, etc. US (and foreign) transfer pricing issues on related party transactions Foreign tax exposure Typically the US owner is not liable for foreign income taxes on net profits associated with the foreign subsidiary (the subsidiary itself files a local country tax return and pays foreign taxes) Foreign income taxes available as §902 FTCs on US return when profits repatriated via dividends Potential foreign currency implications - §§986 & 989 Use this slide to briefly summarize the implications of operating through a foreign subsidiary corporation for US taxpayers. Later slides cover the basic foreign currency issues and check the box. A later module deals with tax treaties in general.

Foreign Currency Issues
The next set of slides briefly summarize key principles in foreign currency. This course does not contain a separate module on foreign currency tax rules. Rather, key foreign currency rules are summarized at points in the course related to the underlying transactions. Detailed foreign currency rules are beyond the scope of this introductory course. More detailed training is available at Tax SELECT and via external texts. Foreign Currency Issues

Purpose of Foreign Currency Rules
Operations conducted through foreign branch or subsidiary usually denominated in a foreign currency When results of foreign operations are included in the US tax return, they must be reported in US dollars Income and expenses Gains and losses Foreign income taxes Foreign withholding taxes

Key Currency Statutory Authority
Definitions Functional currency - §985 QBU - §989 Appropriate exchange rate - §989 Branch Transactions (§987) Taxable income or loss Transfers of branch property Foreign exchange “exposure pool method” Disposition/Termination of branches Foreign Taxes & Transactions with Foreign Corporations (§986) E&P pools Dividends and associated §902 FTCs Previously taxed E&P (PTI) Foreign tax pools The foreign exchange exposure pool method is adopted by the 2006 proposed 987 regulations. These are quite a departure from the 1991 proposed regulation method. Method requires indication of “marked” and “historic” 987 items, with different exchange rates used for translation.

Key Currency Statutory Authority (cont’d)
§988 Transactions – taxed as ordinary income Taxpayer acquires and disposes of instruments denominated in a nonfunctional currency or instruments determined by reference to the value of a nonfunctional currency (§988 transactions) Taxpayer acquires or becomes the obligor under a debt instrument Taxpayer enters into or acquires any forward or futures contract, option, or any similar financial instrument Taxpayer holds foreign currency as an investment or enters into a foreign exchange contract (hedging)

Key Issues in Foreign Currency Translation
When are transaction results translated? Transaction by transaction--nonfunctional currency Net profit or loss method--functional currency Foreign exchange “exposure pool method” The foreign exchange exposure pool method is adopted by the 2006 proposed 987 regulations. These are quite a departure from the 1991 proposed regulation method. Method requires indication of “marked” and “historic” 987 items, with different exchange rates used for translation.

Basic Principles For US income tax purposes, a taxpayer and each “qualified business unit” (QBU) must make all of its determinations in its “functional currency” - §985(a) Functional currency is the currency of the “economic environment” in which a significant part of the QBU’s activities are conducted, and which is used by the QBU in keeping its books and records

Implications of Transfer Pricing
This course does not contain a formal module on transfer pricing. Rather, transfer pricing concepts are introduced here at a very broad level. The point of this discussion is NOT to address the specific transfer pricing methods, etc. Instead, focus on the key idea that Sec. 482 (and foreign statutes) require arm’s length pricing among related parties, certain methods and documentation are required, and significant penalties can apply in the case of transfer pricing disputes. Also point out that virtually all ITS transactions and structures have significant transfer pricing implications and involvement by transfer pricing professionals is often an important component of an ITS engagement. Throughout the course, the instructor should remind participants of transfer pricing implications when relevant to the discussion. Implications of Transfer Pricing

Why Is Transfer Pricing Important?
Virtually all ITS strategies require effective use of transfer pricing strategies to optimize a company’s global effective tax rate Every jurisdiction wants to tax a portion of an entity’s income Risk of double taxation (two or more countries want to tax the same income) Transfer pricing penalties have been enacted by the US and all major U.S. trading partners

Section 482 In any case of two or more organizations, trades, or businesses (whether or not incorporated, whether or not organized in the United States, and whether or not affiliated) owned or controlled directly or indirectly by the same interests, the Secretary may distribute, apportion, or allocate gross income, deductions, credits, or allowances between or among such organizations, trades, or businesses, if he determines that such distribution, apportionment, or allocation is necessary in order to prevent evasion of taxes or clearly to reflect the income of any of such organizations, trades, or businesses. In the case of any transfer (or license) of intangible property (within the meaning of section 936(h)(3)(B)), the income with respect to such transfer or license shall be commensurate with the income attributable to the intangible.

What Does Transfer Pricing Apply To?
Tangible goods Financing Intercompany loans, accounts receivable, guarantees Services Management fees, potential transfer of intangibles Intangibles Royalties, cost sharing, buy-in payments, sale of intangible Simply mention that different methods are allowed in different contexts. Do not address the various methods as this is beyond the scope of the course.

Transfer Pricing Penalties - Reg. §1.6662-6
The regulations encourage taxpayers to: Make a serious effort to comply with the arm’s length standard in setting prices for controlled transactions Report an arm’s length result on their income tax return Document their transfer pricing analysis Provide documentation to the IRS upon request

Key Transfer Pricing Penalties
Substantial Valuation Misstatement 20 percent of additional tax Gross Valuation Misstatement 40 percent of additional tax Treas. Reg. §

Foreign Tax Credit PwC

Foreign Tax Credit Overview
Facilitation Notes Foreign Tax Credit Overview

Methods for Avoidance of Double Taxation
Exclusion of non-U.S. source income (e.g., §911) Deduction for foreign taxes - §164(a)(3) Income tax treaty arrangements Foreign tax credit - §§ Point out that several different methods exist under US law to mitigate double taxation. Some methods only work in very specific situations (e.g., foreign earned income exclusion of Sec. 911). But the primary method US taxpayers use to avoid double taxation is the FTC.

Deduction vs. Credit For Foreign Taxes
Annual election to claim a credit or a deduction – Form 1118 or 1116 Must be consistently applied in any one year 10 year statute of limitations (not 3 years) Permits taxpayers to claim credit or deduction based on subsequent events Reg. § (d) and §6511 Note that a copy of Form 1118 is included as an Exhibit in the materials. This may be a good time to have the participants look at this form. Emphasize that the statute of limitations is quite different for the FTC.

Situations When Claiming Foreign Taxes As Deductions May Be More Advantageous
U.S. taxpayer has a Net Operating Loss and credits would expire unutilized Foreign tax Credit - 1 year carryback and 10 year carryforward - §904(c) Carryback is not elective Carryovers are applied on a FIFO basis, with the current year FTC being used first Short tax years count as full years for carryover purposes A year in which the taxpayer elects to deduct foreign taxes counts in the carryover period Net Operating Loss - 2 year carryback and 20 year carryforward Taxpayer is limited in the amount of foreign taxes which may be claimed as a credit Often caused by substantial expense apportionment against foreign source income (as discussed later) Point out that although credits are typically better, they are not better if they can’t be used! Two typical situations are excess credits based on losses (no US tax to offset) or based on the Sec. 904 limit. Either way, a 20 year carryforward period for the deduction (i.e., larger NOL) is better than nothing. 2 year carryback and 5 year carryforward for tax years beginning prior to 10/22/04

Types of Foreign Tax Credits
Direct credit - §901 “In lieu of” credit - §903 Deemed paid (indirect) credit - §902 and §960 A withholding tax is an example of an “in lieu of” credit.

Who Can Claim a Foreign Tax Credit?
US persons For conduit entities: partners, S Corp. shareholders, and trust and estate beneficiaries (if otherwise qualified) Resident aliens Foreign persons conducting a U.S. trade or business §§901(c) and 906 Briefly note who can claim a credit. Foreign persons can only claim credits related to foreign taxes imposed on US effectively connected income. Sec. 906.

When to Claim the Credit
Allowable when “paid or accrued” - §905(a) Cash method taxpayer When paid A cash method taxpayer can elect to use the accrual method Accrual method taxpayer Taxes are creditable when the “all events” test is met and the amount and liability are fixed File Form 1118 (corporations) or 1116 (individuals) Proof of credits (foreign taxes) - §905(b)

Translating Foreign Taxes - §986(a)
Cash method taxpayers Use the spot rate on the date the tax was paid (or withheld) Accrual method taxpayers Use the average exchange rate for the year to translate all taxes for the year Withholding taxes Estimated tax payments Taxes accrued at year-end Election to use the spot rate is allowed for taxes paid in non-functional currency - §986(a)(1)(D) & (E) Note that President Clinton proposed in his 2001 budget to use the spot rate when translating withholding taxes, regardless of the taxpayer’s accounting method. This approach would have made the translation of the tax consistent with the rate used to translate the income distributed on which the tax was withheld (i.e., the spot rate for dividend translation). This proposal never became law, but the 2004 Jobs Act did modify the rules to allow election for spot rate in the case of taxes paid in non-functional currency. Taxes accrued at year-end and paid in a future year No adjustment is made for exchange rate differences if the amount accrued at year-end (in foreign currency) is paid within two years of the year accrued If the amount accrued (in foreign currency) is paid after the two year period, the FTC is removed from the tax return in the year accrued If the foreign tax is subsequently paid after the two year period, the tax is translated using the spot rate on the date paid and is allowed as a credit in the year in which the tax accrued In either case, the taxpayer must file an amended return (Form 1120X or Form 1040X)

FTC Limitation Formula - §904
Foreign Foreign Source Tax = Taxable Income US Tax Credit Within Basket x Before FTC Limit Total Taxable Income Allowed FTC is the lesser of: Creditable foreign income taxes -§§901 – 903 FTC limit - §904 See Form 1118 Introduce the basic FTC limit formula. Point out that much of the later discussion will address (1) what foreign taxes are creditable and (2) what constitutes foreign source taxable income.

Creditable Foreign Taxes

Creditable Taxes - Requirements Of A Creditable Tax
In general §901(b) allows a credit against U.S. income tax for "any income, war profits and excess profits tax paid or accrued...to any foreign country or to any possession of the United States" §903 states that the term "income, war profits, and excess profits taxes" shall include a tax paid "in lieu of" an income tax These slides illustrate that not all foreign taxes are creditable.

Requirements Of A Creditable Tax (cont’d)
A foreign levy is a creditable income tax if: it is a tax; it requires a compulsory payment a penalty, fine, interest or similar obligation is not a tax, neither is a customs duty a tax must exhaust all effective and practical remedies, including the invocation of competent authority must be paid to a foreign government without receipt or consideration of a direct or indirect specific economic benefit; the predominant character of the tax is an income tax in the US sense Whether a foreign levy is an income tax is determined independently for each separate levy Reg. §

Reg. § (b)(1) requires that the tax have the predominant character of an “income tax in the U.S. sense” Realization Gross receipts Net income Issue of “technical taxpayer” can arise in determining who is eligible for the credit [beyond scope of course]

Realization test - Reg. § (b)(2) The tax must be imposed when “net gain” is “realized” in the US sense The tax must be imposed as the result of a “transaction” Gross receipts test - Reg. § (b)(3) The tax is imposed on net gain attributable to actual gross receipts The test may be satisfied if the government uses a formula to approximate gross receipts provided the result is not greater than the fair market value of the services provided by the taxpayer

Net income test - Reg. § (b)(4) The tax is imposed on gross receipts less significant costs and expenses Costs include capital expenditures (depreciation). Allowances are acceptable if the resulting tax base approximates net income

“In Lieu Of” Income Tax – §903
The tax must substitute for the general income tax. The charge must approximate the tax that would result under the general income tax Withholding taxes imposed on gross receipts generally qualify as “in lieu of” income taxes Withholding taxes are imposed for administrative convenience

Non-Creditable Foreign Taxes
Non-income taxes (property taxes, excise taxes, VAT, etc.) Subsidies Any benefit conferred, directly or indirectly, by the foreign country to the taxpayer - Reg. § (e)(3)(ii) Taxes paid to “§901(j) countries” Cuba, Iran, North Korea, etc. Soak-up taxes A foreign tax is not a creditable income tax to the extent it would not be imposed but for the availability of an income tax credit of another country - Reg. § (c)

§902 Indirect Foreign Tax Credits

Deemed Paid FTC: Example (branch with direct tax)
If a US corporation earns foreign income through a branch, the US corporation pays the foreign tax directly and receives a credit under Sec. 901 (i.e., a direct credit) US corporation will include $1,000 in gross income and claim a foreign tax credit of $250, subject to any limitation US Corp Foreign Branch Foreign Income 1,000€ Foreign Tax $ 250 Use the next two slides to illustrate the policy implications of the Sec. 902 credit. That is, the rules are trying to equate the treatment of earning income and paying taxes through a foreign branch vs. a foreign subsidiary. Assume $1 : 1€

Deemed Paid FTC: Example (foreign subsidiary)
If a US corporation earns foreign income through a sub and repatriates all the after-tax profits, the US corporation has not directly paid any foreign taxes and thus can’t receive a Sec. 901 FTC However, under §902, the US corporation will treat the $250 of taxes paid by the foreign sub as a FTC in the U.S. US corporation will include the $1,000 in gross income ($750 dividend plus $250 §78 gross-up) and claim a foreign tax credit of $250, subject to any limitation US Corp $750 Dividend Foreign Income ,000€ Foreign Tax $ 250 Foreign E&P € Foreign Sub The pooling concept of E&P and tax pools are addressed in upcoming slides. Assume $1 : 1€

FTC - Deemed Paid Tax Calculation
Dividend* or “Deemed Dividend”* Post-86 Foreign = §902 FTC Post-86 Undistributed x Tax Pool Earnings * before §78 gross-up Point out the “pooling” approach of post 1986 years. This method essentially “averages” the effective tax rate on the foreign corporation’s E&P pool. Note that distributions of pre-1987 E&P require use of the specific year identification that matches E&P and foreign taxes from particular years. Calculation using this method is beyond the scope of this course. Functional Currency US Dollar

Foreign Currency Issues
Foreign taxes translated each year into U.S. dollars using the appropriate rate - §986(a) Foreign corporation E&P is maintained in functional currency - §986(b)(1) Ratio of dividend to undistributed earnings is determined with both amounts in functional currency Actual dividend distribution is translated at spot rate - §989(b)(1) Consequently, no FX gain or loss is triggered with actual dividend distributions (i.e., income inclusion and translation occur at the same time) The fact that the tax pool is maintained in US dollars and the E&P in functional currency sets up the potential for the effective tax rate on foreign earnings to be quite different from the original rate at which such earnings were taxed. That is, movements in FX rates can make the effective tax rate higher or lower.

Sourcing Income and Expenses

Purpose of Sourcing Rules
Gross Income Sourcing Rule Point out the general purpose of the source rules for identifying the appropriate source of various types of gross income Note that “foreign source’ may have multiple “baskets” for purposes of the Sec. 904 FTC separate limitations Foreign Source / Basket U.S. Source

Purpose of Sourcing Rules (cont’d)
Gross Income Deductions Sourcing Rules Allocation & Apportionment Note that we must source both gross income AND deductions. We refer to the sourcing of deductions as “allocation & apportionment” Foreign Source / Basket Foreign Source / Basket U.S. Source U.S. Source

Sourcing Implications – U.S. Persons
Determination of FTC limitation - §904 FTC Limitation = Foreign Source Taxable Income (within Basket) x U.S. Income Tax Before FTC Total Taxable Income Point out that U.S. persons – although taxed on their “worldwide” taxable income -- care about the level of foreign source income because it directly affects their FTC limitation through the numerator of the FTC limit formula. From a planning perspective, U.S. taxpayers want to maximize foreign source taxable income, all else equal. Keep in mind that characterization as foreign source income for U.S. purposes typically has NO effect on whether a foreign jurisdiction will tax such income.

U.S. Framework for Sourcing Gross Income
Predominant Situs Residence of Recipient Split Source Three general approaches to sourcing income with some overlap and special exceptions

Predominant Situs Income classified based on the location of the economic activity that produced the income Examples include interest, dividends, personal services income, rents, royalties, sale of real property, sale of certain personal property, certain transportation income, insurance underwriting income, and social security benefits

Residence of Recipient
Income classified based on the residence of the recipient Examples include sale of personal property other than inventory, ocean or space income, and certain foreign currency gains and losses

Split Source Income classified as part U.S. source and part foreign source using a statutory or regulatory formula Examples include transportation and international communications income

Process for Sourcing Gross Income
Step #1 Determine gross income category Step #2 Apply category specific source rule Point out that often the difficulty in sourcing income is in determining the nature of the income item. For example, does a payment for IP represent a royalty or the amount realized on the sale of the property. Depending on the nature of the payment, the source can be different. Another example is the sourcing of software income. Is the sale of software considered the sale of an inventory item or the licensing of the software? This course will address these software rules in more detail later.

Gross Income - Statutory Categories
Interest §§861(a)(1) and 862(a)(1) Dividends §§861(a)(2) and 862(a)(2) Personal services income §§861(a)(3) and 862(a)(3) Rentals and royalties §§861(a)(4) and 862(a)(4) Disposition of U.S. real property interests §861(a)(5) Sale of inventory §§861(a)(6), 862(a)(6), and 863 Sale of personal property other than inventory §865 Insurance underwriting income §§861(a)(7) and 862(a)(7) Social Security benefits §861(a)(8) This slide provides the major types of gross income and related authority. It may be useful to have the participants look at the code sections during this discussion.

Roadmap To Source of Income Rules
§861 provides primary rules on sourcing gross income by indicating what constitutes US source income §862 indicates that foreign source income for the items listed in §861 are simply all items that are not US source §863 delineates the sourcing of Income derived partly within and partly from without the U.S. - §863(b) inventory sales Transportation income Space and certain ocean activities income International communications income

Roadmap To Source of Income Rules (cont’d)
§864 contains definitions and special rules “Defines” trade or business within United States Defines effectively connected Income Certain rules for allocating interest and other expenses §865 contains detailed rules on the source of income form the sale of personal property General rule - Source of income determined by reference to the residence of the seller Inventory - §§861(a)(b), 862(a)(b) and 863 Depreciable personal property (depreciation recapture) Intangible assets (treated as a royalty if payments are contingent upon) Stock of 80% owned affiliates Sales through offices or fixed places of business

Interest Income General rule - Sourced according to the residence of the payer §§861(a)(1) and 862(a)(1) See §7701 to determine residence Major exceptions Interest from foreign branch of US bank US “80-20” company (proposed repeal by “Green Book”) Special rules for payments of interest by a U.S. branch of a foreign corporation [§884] or certain foreign partnerships [§861(a)(1)(C)] Note that the “Green Book” proposes repeal of the “80-20” company rules

Interest From Foreign Branch of US Bank
Interest paid on deposits with a foreign branch of a US corporation or partnership is treated as foreign source income if the branch is engaged in the commercial banking business - §861(a)(1)(B)(i) As long as the interest income is not effectively connected with a US trade or business, no US withholding tax is imposed on the interest payments - §871(i)(2)(A) and §881(d)

Dividend Income General rule - dividends are sourced according to the residence of the payer §§ 861(a)(2) and 862(a)(2) Exceptions 25% Look-through rule for foreign corporations with US trade or business U.S. withholding tax on such U.S. source income is repealed effective for payments after 12/31/2004 US “80-20” Company (proposed repeal)

Personal Services Income
Personal services income is sourced based on where the services are performed - §861(a)(3) and §862(a)(3) Services performed both within and outside the U.S. generally must be allocated based on time spent - Treas. Reg.§ (b)(1)(i) There is a de minimis rule for nonresident aliens who work temporarily in the United States (the so-called “commercial traveler” exception)

Rent Income In general, rental income is sourced based on the place where the property is located or used - §861(a)(4) and §862(a)(4) The taxpayer must apportion the rental income on the basis of time, mileage, or some other appropriate base, if the property is used both inside and outside the US

Royalty Income Royalty income generally is sourced based on the place where the intangible property is used - §861(a)(4) and §862(a)(4) Intangibles include patents, copyrights secret processes, know-how, customer lists, goodwill, trademarks, trade brands (see also §197 and §936(h)(3)(B) for other types of intangibles)

Computer Software Income
“Licensing’ of computer software to a customer in exchange for a “royalty” might constitute a royalty, rental income from the lease of the diskette/program, or sales proceeds from the sale of the diskette/program Regulations provide guidance on classifying transactions that involve computer programs -Reg.§ Note that the rules for computer software income relate to determining what the character of the income is...and then the sourcing rules for that type of income apply.

Real Property Income In general, gains from the sale or exchange of real property are sourced according to the location of the property - §861(a)(5) Special rules with regard to the Foreign Investment in Real Property Tax Act of 1980 (FIRPTA) - §897 (as discussed in later module)

Personal Property Other Than Inventory
General rule - Gain from the sale or exchange of personal property other than inventory is sourced according to the residence of seller - §865(a) Numerous exceptions exist within §865 US citizens or resident aliens are residents of the United States for this purpose unless they have a “tax home” in a foreign country, in which case gains will still be US source unless an income tax of at least 10% of the gain is actually paid to a foreign country - §865(g)(1) and (2)

Inventory Income Purchased Inventory Manufactured inventory
Gross income from the sale of inventory purchased for resale is sourced on the basis of where the sale occurs, i.e., “the title passage rule” - §861(a)(6) and §862(a)(6) Manufactured inventory Source partially within the US and partially without the US Referred to as “§863(b) income” General rule is the method - Reg. § Source based on property factor and sales factor Can elect to use the “Independent Factory Price”

Allocation & Apportionment of Expenses

Allocate vs Apportion Deductions
Step 1 – Allocate to class of gross income Step 2 – Apportion between statutory and residual groupings Reg. § Participants often struggle with the difference between allocate and apportion. Use the next few slides to illustrate this difference. Point out that statutory grouping depends on what the purpose of the calculation is....Foreign source is the statutory grouping if trying to calculate a FTC limit under Sec. 904.

Allocation Absent any special rules, allocate deductions to a class of gross income that represents a specific income-producing activity or property A deduction is allocated to a class if it is definitely related to a class of gross income Deduction is definitely related if “incurred as a result of or incident to” the activity or property that gave rise to the gross income - Reg. § (a) and (b) A deduction may be definitely related to all of the taxpayer’s gross income - § (b)(5)

Apportionment After allocation among gross income, deductions within a class of income are then apportioned to statutory groupings and residual groupings based on any reasonable method - Reg.§ T(c)(1) Statutory grouping is gross income that, when reduced by deductions, becomes relevant under a particular operating provision (e.g., foreign source income within a basket when computing the foreign tax credit) - Treas. Reg.§ (a)(4) Residual grouping is the remaining gross income not included in the statutory grouping Expenses must be apportioned to US and foreign sources on a basis that “reflects to a reasonably close extent the factual relationship between the deduction and the grouping of gross income” - Reg.§ T(c)(1) The effect of an apportionment on the taxpayer’s tax liability and record-keeping burden is considered when determining whether an apportionment is sufficiently accurate - Reg.§ T(c)(1)

Expenses Related to All Gross Income
SG&A expenses may be apportioned based on any reasonable method Taxpayers have some flexibility here because the factual relationship between SG&A expenses and income is usually subjective

Expenses Not Definitely Related to Any Gross Income
Deductions not definitely related to any gross income are apportioned between statutory and residual groupings based on gross income - Reg.§ (c)(3) Examples include Real estate taxes on a personal residence Medical expenses Charitable deductions Alimony See Reg. § (e)(9)

Research and Experimental Expense (R&D)
US corporations must allocate and apportion research costs to foreign source income if the corporation has foreign sales or gross income - Reg. § This apportionment is required without regard to where the R&D activity is performed

FTC Limitation

FTC Formula: Separate Baskets
Foreign Foreign Source Tax = Taxable Income US Tax Credit Within Basket x Before FTC Limit Total Taxable Income

FTC - Impact of Baskets Baskets limit the ability to “cross credit” foreign taxes on high-taxed foreign source income against US residual tax on low-taxed foreign source income Planning objective is to mix high- and low-taxed foreign source income within same basket

FTC - Separate Baskets - § 904
For tax years beginning after 12/31/2006 Passive Income (i.e. interest, rents, royalties, etc.) All other income (i.e., the “general” basket) Note that carryforwards from pre-2007 baskets were assigned to either the passive or general basket as appropriate Note the simplification created with this 2004 Jobs Act basket reduction.

Passive Income Basket Passive income is any income that meets the definition of foreign personal holding company income - §954(c) Passive income generally includes: Dividends Interest Rents Royalties Annuities Gains from sale of property Net commodities gains Net foreign currency gains

Passive Basket “Kick-outs” - §904(d)(2)
Certain passive income is “kicked out” of the passive basket and into the general limitation basket Export financing interest High-taxed income (passive income subject to an average foreign tax rate exceeding the top U.S. marginal tax rate) Rents and royalties derived from the active conduct of a trade or business Point out that the passive basket stands last in line. That is, any of these other baskets take precedence when determining the appropriate basket.

General Limitation Income Basket
The general limitation basket is the residual basket for all other “unclassified” income General limitation income includes Active trade or business income (high and low taxed) Export financing interest High-taxed passive income Rents and royalties from an active trade or business Income from “base differences” (foreign income taxed that is not included in income under U.S. principles) – tax years beginning after 12/31/2004

Income Tax Treaties PwC

Objectives of Income Tax Treaties
Reduce or eliminate double taxation of income earned in one country by a resident of another country Avoid excessive rates of taxation Stimulate cross-border investment via tax reduction and certainty of treatment Promote cooperation among countries in enforcing and administering tax laws Prevent the tax laws of one country from discriminating against residents of another country

Mitigating Double Taxation
Cross-border investment or transactions may give rise to an income tax exposure in two or more taxing jurisdictions Taxpayer’s country of residence (home country) Country where income is earned (source country) Cumulative taxation by both the home and source country is disruptive to cross-border trade and countries attempt to solve double taxation problems with either an exemption system or a foreign tax credit system These unilateral local-country statutory measures do not always provide adequate relief from double taxation

Categories of Income Addressed by Treaties
Income taxed in source country Business profits attributable to a permanent establishment Real property income Income subject to limited taxation in source country Passive income (dividends, interest, rents, royalties) Income earned by teachers, trainees, artists, athletes, etc. Income subject to tax in home country only Gains from the sale of personal property (not connected with PE and not subject to FIRPTA)

Taxes Addressed by Treaties – U.S. Model, Article 2
U.S. taxes Federal income taxes Federal excise taxes on private foundations Not federal social security taxes Not state and local taxes Foreign taxes As specifically listed in each treaty

U.S. Income Tax Treaty Network
U.S. has income tax treaties with over 60 countries Most European countries and other major trading partners (e.g., Mexico, Canada, Japan, China, Australia, former Soviet Union countries) Many “gaps” in U.S. tax treaty network South America Africa Asia Middle East

Creation of Income Tax Treaties
Income tax treaties are bilateral agreements between two countries Model tax treaties are used as starting points for negotiation Treaties may be amended with “Protocols” or replaced with new treaties

? Key Treaty Questions Does an income tax treaty exist?
Has the treaty entered into force (and not been terminated)? Is the taxpayer eligible for treaty benefits? How does the treaty apply to a specific activity or item of income? ?

Treaties vs. U.S. Statutory Law
Treaties have equal standing with provisions of the U.S. Constitution and with U.S. domestic laws The Constitution’s Supremacy Clause (Article VI, Sec. 2) provides: “This Constitution, and the laws of the United States which shall be made in pursuance thereof, and all treaties made, or which shall be made, under the authority of the United States, shall be the supreme law of the land.” Whitney v. Robertson, 124 U.S. 190, 194 (1888): Both treaty and statue are declared by the Constitution to be the supreme law of the land, and no superior efficacy is given to either over the other.

Treaties vs. Law - Section 894(a)
Current The provisions of this title shall be applied to any taxpayer with due regard to any treaty obligation of the United States which applies to such taxpayer. Prior to 1988 Amendment Income of any kind, to the extent required by any treaty obligation of the United States, shall not be included in gross income and shall be exempt from taxation under this subtitle.

Treaties vs. Law - Section 7852(d)
Current For purposes of determining the relationship between a provision of a treaty and any law of the United States affecting revenue, neither the treaty nor the law shall have preferential status by reason of its being a treaty or law. Prior to 1988 Amendment No provision of this title shall apply in any case where its application would be contrary to any treaty obligation of the United States in effect on the date of enactment of this title.

Last-in-Time Rule Courts should first try to resolve apparent conflicts by seeking an interpretation that avoids inconsistency When treaty and law are inconsistent the last one in time will control the other A treaty may supersede a prior act of Congress, and an act of Congress may supersede a prior treaty A number of “treaty overrides” have been enacted by Congress Examples include FIRPTA, the branch profits tax, §163(j) Generally requires clear Congressional intent to override treaties

Mutual Agreement – Competent Authority (Article 25)
The mutual agreement article provides for resolution by the tax authorities of disputes and situations not adequately addressed in the treaty Generally not limited by remedies provided by the domestic law of either country or the time limits prescribed in such laws for presenting claims for refund Competent authority not required to reach an agreement (but should make a good faith effort)

Organization of a Treaty
General Rules Article 1--General Scope Article 2--Taxes Covered Article 3--General Definitions Article 24--Non-Discrimination Article 28--Entry into Force Article 29--Termination Eligibility for Treaty Benefits Article 4—Residence Article 22--Limitation on Benefits Double Tax Relief Article 23--Relief from Double Taxation Article 25--Mutual Agreement Procedure Instructor should briefly note the various articles. Also note that only the key articles will be addressed in any detail in the course materials.

Organization of a Treaty (cont’d)
Administrative Cooperation Article 26--Exchange of Information and Administrative Assistance Ability to Tax Income Article 5--Permanent Establishment Article 6--Income from Real Property (Immovable Property) Article 7--Business Profits Article 8--Shipping and Air Transport Article 9--Associated Enterprises Article 10--Dividends Article 11--Interest Article 12--Royalties Article 13--Gains

Organization of a Treaty (cont’d)
Ability to Tax Income (cont’d) Article 14—Income from Employment Article 15—Directors Fees Article 16—Entertainers and Sportsmen Article 17--Pensions, Social Security, Annuities, Alimony, and Child Support Article 18 – Pension Funds Article 19--Government Service Article 20--Students and Trainees Article 21--Other Income Article 27--Diplomatic Agents and Consular Officers

Residency – Article 4 Individuals Corporations
Treated as a resident of the country in which subject to tax by reason of domicile, residence or citizenship Corporations Treated as a resident of the country in which subject to tax by reason of place of management, place of incorporation, or similar criteria Fiscally transparent entities Income of a fiscally transparent entity is treated as income derived by a resident to extent the income is taxable to a resident

Residency (cont’d) Certain tax-exempt entities
Qualified governmental entities A person is not a resident of a country simply because such person is subject to tax in the country with respect only to: Income derived from sources within the country, or Business profits attributable to a permanent establishment located in the country

Permanent Establishment – Article 5
Existence of a PE within a country creates income tax exposure within source country Similar to “carrying on a trade or business” concept in U.S. tax law “Trade or Business” not defined by the Code PE rules provide more certainty and safe harbors

PE Defined A fixed place of business through which the business of an enterprise is wholly or partly carried on a place of management, branch, office, factory, or workshop a mine, an oil or gas well, a quarry, or any other place of extraction of natural resources a drilling rig or ship used to explore for natural resources if the activity lasts longer than 12 months a construction or installation project that lasts longer than 12 months

PE Exclusions A PE does not include:
facilities used solely to store, display, or deliver goods belonging to enterprise maintenance of a stock of goods solely for purpose of storage, display or delivery, or processing by another enterprise maintenance of a fixed place of business solely to purchase goods, collect information, or any other activity of a "preparatory or auxiliary" nature

PE Attribution Through Other Entities
Subsidiary – Article 5(7) Simply owning control of a subsidiary corporation does not create a PE for parent corporation in the subsidiary country The activities of a subsidiary could create a PE for parent if the subsidiary is considered a dependent agent and habitually exercises an authority to conclude contracts in the parent’s name (Taisei Fire and Marine Co. Ltd. 104 T.C. No. 27 (1995); OECD Commentary, Article 5(41)) Partnership The PE of a partnership is imputed to the partners (Rev. Rul ; Unger, 936 F2d 1316, DC Cir., 1991)

PE Attribution Through Agents
Independent agents Doing business through an independent agent does not create a PE, provided the agent is acting in the ordinary course of its business as an independent agent Dependent agents Dependent agent can create a PE if the agent habitually exercises an authority to conclude contracts that are binding on taxpayer

Business Profits – Article 7
Business profits are those profits the PE would earn “if it were a distinct and independent enterprise engaged in the same or similar activities” Includes only income “derived from the assets or activities of the permanent establishment” Deductions allowed for direct PE expenses and a reasonable allocation of indirect expenses Generally narrower definition than the “force of attraction” rule under §864(c)(3) for foreign persons engaged in a U.S. trade or business

U.S. Model Treaty Other Specific Articles
Dividends - General Rule: 15%; Rate reduced to 5% if recipient has a substantial ownership interest (generally 10% or 25%); certain newer treaties (e.g., Japan, Australia, UK and Mexico) provide for no withholding in certain circumstances Interest - U.S. Model grants the exclusive right to tax interest to the recipient’s country of residence. However can see interest W/H between 5 – 17.5% Royalties - U.S. model grants the exclusive right to tax royalties to the recipient's country of residence. However can see royalty W/H between % Capital Gains on sale of personal property - Many U.S. treaties grant the exclusive rights to tax capital gains to the county in which the seller is resident. However FIRPTA provisions override this general rule

Role of Treaties in International Tax Planning
Tax treaties are an important tool in tax planning Inbound Outbound Foreign-to-foreign Provide greater level of certainty as to tax exposure Reduce withholding taxes Provide mechanisms for resolving tax disputes

Planning Concepts PwC

Framework for Planning Opportunities

Best Practices Components of an Integrated Global Structure

Planning Opportunities
Migration and deferral Finance and risk management Jurisdictional Legislative The next few slides provide examples of the types of planning opportunities available to help clients efficiently arrange their structure from a tax point of view.

Migration and Deferral
& Deferral Strategies New Plants Tax-Favored Locations Commissionaire and Strip-Risk Marketing R&D Cost-Sharing Contract Manufacturing Flexible and Effective Transfer Pricing Policy Low-Taxed Trading Companies Low Profit Functional Service Centers Note: Later slides provide examples of FAS 109 and APB 23 issues. Tax-Favored Legal Structure, Including Holding Companies APB 23

Finance and Risk Management
Finance & Risk Management Strategies Creating Debt Through Intercompany Asset Sales Formal Capital Reductions Dividend Strips Hybrid Instruments Tax- Advantaged Leasing Captive Insurance Companies Factoring of Receivables Treasury & Cash Management Export Incentive Enhancement Risk Management & Financial Products Optimize Cross-Border Withholding Taxes Capital Loss/Gain Strategies

Jurisdictional Jurisdictional Strategies Internal Tax Free
Local Incentives, e.g., Research Credits, Investment Incentives Internal Tax Free Asset Step-Ups and Revaluations Tax Holidays and Special Tax Zones Tax Structure, Branch, Subsidiary, etc. Local Imputation System Benefits Monetize Deferred Tax Assets Conversion of Ordinary Income to Tax Rate Favored Income Export Tax Incentives Special Purpose Vehicles Indirect Tax Reduction

Legislative Legislative Strategies Promoting Favorable Tax Treaties
Lobbying for Reduction in Cross-Border Withholding Taxes Promoting Favorable Tax Treaties Protecting Tax Favored Treatment of Income Sources and Taxation Maintaining Incentives FASB Initiatives (APB 23, etc.) WTO Initiatives Negotiate Indirect Tax Rates and Credits

Key Planning Ideas Take advantage of US and foreign tax incentives
Deferral of US tax on foreign source income Cash tax and financial statement tax expense (ASC FAS 109 & APB 23) Maximize use of foreign tax credits Manage FTC limit Reduce foreign income taxes & withholding taxes Manage profit portability potential of global profits Optimum placement of intangible property Optimum use of debt financing, technology charges, management fees Use of entities and structures that allow optimum placement of profits and losses (e.g., use of buy/sell distributors, commissionaires, and contract manufacturers)

Profit Portability Potential
Ability to Align or Realign Profits in Taxing Jurisdictions to Optimize Tax Rates Around the World Profit Portability Potential

Profit Portability Potential
Break profits into components by business process Analyze business risks and the related profits Migrate profits to lower-tax jurisdictions Consider migration opportunities Consider tax risk tolerance

Introduction to International Taxation

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