International Tax Jurisdiction—Basic Concepts

Key issues governments must resolve when taxing cross-border trade

-- What persons to tax?-- What income to tax?

Factors that trigger taxation

Personal relationship Country of incorporation or residence

Economic relationship Country in which a business has income producing assets or activities

Outbound Transactions

Foreign Source Income Domestic Foreign

Corporation Operations

Foreign InvestmentForeign Investment

“U.S. persons” (§7701) * Foreign Source Income

U.S. citizens Resident aliens Domestic corporations Domestic Partnerships

Inbound Transactions

U.S. Source Income Foreign U.S.

Corporation Operations

U.S. InvestmentU.S. Investment

Foreign Persons (§7701) * US Source Income

Non resident aliens Foreign corporations Foreign partnerships

U.S. Taxation of Outbound Transactions

Foreign Source Income Domestic Foreign

Corporation Operations

Foreign InvestmentForeign Investment

Credit System Low-tax foreign countries U.S. collects “residual” U.S. tax High-tax foreign countries U.S. collects no tax and credit is limited

to US tax on foreign income Major Exceptions

Deferral privilege (subject to Subpart F, PFIC and FPHC regimes) Foreign earned income exclusion (§ 911)

U.S. Taxation of Inbound Transactions

U.S. Source Income Foreign U.S.

Corporation Operations

U.S. InvestmentU.S. Investment

Two-pronged territorial system U.S. branch operations Net basis tax on “effectively connected” income Passive foreign investors Gross basis withholding on U.S. source non

business income Major exceptions

Capital gains and portfolio interest exemptions U.S. real property interests (FIRPTA) Treaty reductions

Computing the Foreign Tax Credit Procedure

Compute creditable taxes (“All or Nothing”) Compute foreign tax credit limitation Credit = Lesser of creditable taxes or FTCL Excess credits: Back 2 years, forward 5 years

Computing creditable taxes (Step 1 above) Qualifying (by treaty) foreign levies (§§ 901,903) Taxpayers entitled to claim a credit (§ 901) Currency translation (average exchange rate for year)

(§ 986) Cash v. accrual basis accounting (§905)

[Accrual method election available]

Foreign Tax Credit Limitation (§904) Purpose

Limit credit to U.S. tax on foreign income Credit cannot exceed U.S. tax on U.S.

source income

FormulaPre-credit = Foreign source taxable incomeU.S. tax Total taxable income

Excess Credit vs. Excess Limitation—Impact of Foreign Tax Rate

Facts: Domestic corporation has a

foreign branch. (Note: Branches include legal entities that are “disregarded” under the check-the-box regulations)

Total income of $ 100 is attributable entirely to foreign branch.

U.S. tax rate = 35%Case 1: 20% foreign tax rate

“Excess Limitation”

U.S. tax returnTaxable Income $ 100Tax rate

35%Pre-credit tax $ 35Credit (limit) 20U.S. tax $ 15

Foreign tax returnTaxable income $

100Tax rate

20%Foreign tax $

20*

Excess Credit vs. Excess Limitation—Impact of Foreign Tax Rate (continued)

Case 2:

50% foreign tax rate “Excess credits”

$ 50 Foreign tax (b) - $ 35 U.S. credit limit (a) = $ 15 excess credit

U.S. tax returnTaxable Income $ 100Tax rate

35%Pre-credit tax $ 35Credit (foreign tax) (a) (35) U.S. tax $ 0

Foreign tax returnTaxable income $

100Tax rate

50%Foreign tax (b) $

50

Excess Credit vs. Excess Limitation—Planning Issues Excess limitation position (Subpart F issues)

Tax on foreign income equals foreign tax + residual US tax

Planning: Defer residual US tax Excess credit position (§ 861 planning)

Tax on foreign income equals higher foreign tax

Planning Reduce foreign taxes Increase allowable credit

Strategies for Eliminating Excess Credits Foreign tax reduction planning (discussed

later in the course) Foreign tax credit limitation planning (§ 861)

Increase foreign source portion of total taxable income

Transfer title overseas on export sales Reduce expenses apportioned to foreign source income

Cross-crediting Blend low and high tax foreign source income within the

same Foreign tax credit limitation basket.

Cross Crediting—An ExampleCase 1: Domestic corporation has a branch in country X Total income of $ 100 is attributable entirely to branch in X Tax rates: U.S. = 35% and X = 50%Question: What is the amount of the excess credits?

Foreign income taxes (50% of $ 100) $ 50Average foreign tax rate 50%Limitation:(a) Total taxable income $ 100(b) Pre-credit U.S. tax ($100 x 35%) 35(c) Foreign source taxable income 100

Limitation [b x (c ÷a)] 35

Excess credits $ 15

Cross Crediting—Example (Continued)Case 2: Domestic corporation also has branch in country Y Branch generates $ 100 profit Country Y tax rate is 25%Question: What is the amount of the excess credits?

Foreign income taxes (50% x $ 100) + (25% x $ 100) $ 75Average foreign tax rate ( $ 75 ÷ $ 200) 37.5%Limitation:(a) Total taxable income ( $ 100 + $ 100) $ 200(b) Pre-credit U.S. tax ($ 200 x 35%) 70(c) Foreign source taxable income 200

Limitation [b x (c ÷ a)] ` 70Excess credits $ 5

§904(d) Separate Income Limitations or “Baskets”—Principal Features

Passive income (usually low tax income) “mini-baskets”

High withholding tax interest Dividends from >10%/<50% companies Financial services income (banks) Shipping income (low tax jurisdictions) General limitation income, which includes

most active business profits (e.g. e-commerce) These are usually high income tax jurisdictions

Separate Income Limitations (or Baskets)

Formula Pre-credit U.S. tax X Separate basket foreign tax

inc. Total taxable income

Computation Items of foreign source income and

deductionmust be allocated among the baskets

Foreign income taxes must be allocated among the baskets

Form 1118 Foreign Tax Credit Who must file

Corporations claiming FTC File separate 1118 for each basket

Contents Sch A--Separate basket taxable income Sch B--Foreign tax summary and credit

computation Schs C, D, and E--Deemed paid credit Schs F, G, and H--Supporting computations

Dividend Repatriations from a Foreign Corporation to a U.S. Parent—Tax Consequences

Foreign withholding taxes Pre-credit U.S. tax on dividend income Foreign tax credits

§901 direct credit for withholding tax borne by U.S. parent (branch arrangements, not a corporation)

§902 deemed paid credit for taxes paid by a foreign subsidiary (the dividend from the subsidiary is netnet of the withholding tax)

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 domesticdomestic corporation (does not include S corporations) Shareholder must own 10% or more of voting stock Shareholder must receive dividend distribution

§78 Gross-up income Equals amount of deemed paid credit Tracing foreign taxes to dividends (see next slide)

Pooling Approach of §902(a)

Pool of foreign income taxes

Percentage of E & P distributed

Foreign Dividend receivedDeemed = corporation’s X by shareholder Paid Credit post-1986 Foreign corporation’s

foreign income 1986 undistributed taxes E & P

(excluding the current dividend)

FTCL basketing rules of §904(d) Dividends received from a “CFC”

Controlled Foreign Corporation: More than 50% ownership requirement—follows §902 (a) pooling approach

Dividends received from a 10/50 corporation Look-through rule applies; Dividends from E & P

accumulated before 2003 are assigned to a single company basket that applies to all 10/50 companies. Dividends from eacheach 10/50 corporation from E & P accumulated after 2002 is assigned based on separate baskets.

Definition of 10/50: The domestic corporation owns between 10% and 50% of the foreign corporation

Mechanics of CFC Look-through Rule

Step 1 Post-1986 undistributed Portion of dividend = E & P attributable to basket attributable to basket Total post –1986

undistributed E & P Step 2

Deemed paid Portion of dividend taxes associated = attributable to basket with basket Total post –1986

undistributed E & P attributable to basket

Deemed Paid Credit – Lower Tier Corporations

S econ d T ie rF ore ig n S u b s ia ry

H ob art, Tas .A u s tra lia

F irs t T ie rF ore ig n S u b s id ia ry

S yd n ey, N S WA u s tra ilia

U . S . P aren t C orrp ora tionR ockville , M arylan d

Deemed Paid Credit – Lower Tier Corporations (Continued)

Qualification requirements Minimum 10% direct ownership at each

level Minimum 5% indirect ownership through

chain Dividend Distributions up to U.S. parent

Number of qualifying tiers Historically limited to 1st, 2nd, & 3rd tiers TRA 1997. Extended to 4th, 5th , & 6th tiers

Dividend Repatriations -- Planning

Tax consequences Low tax countries: Residual U.S. tax High tax countries: Excess credits

Annual repatriation program Coordinate dividends to exploit cross-

crediting Structure investments to minimize 10/50

company baskets Use tax treaties to minimize withholding

taxes

Repatriating Profits – Dividends vs. Interest

Taxpayer Attribute Dividend Interest

ForeignSubsidiary

Host country deduction

No Yes

U.S. parent Foreign withholding

tax

Yes Yes

U.S. parent U.S. taxable income

Yes Yes

U.S. parent §901credit for withholding

tax

Yes Yes, §904 (d) applies

No gross-up, interest is an

expense

U.S. parent §902 credit for sub’s foreign

taxes

Yes No

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 $ 0

S’s foreign tax returnProfit pre-interest $ 100Interest expense 0Taxable income $ 100Tax rate .50Foreign tax $ 50

Facts: P, a domestic corporation, owns 100% of S, a foreign corporation S Profit before interest and taxes = $ 100 Tax rates: U.S. = 35%, Foreign = 50% Assume no foreign withholding tax on interest or dividendsConclusion: Total tax = $ 50 (earnings taxed once at the higher

foreign rate)

Earnings Stripping—Example

(Continued)P’s U.S. tax return

Interest Income $ 100Gross-up 0Taxable income $ 100Tax rate .35Pre-credit tax $ 35Credit (0)U.S. tax $ 35

S’s foreign tax returnProfit pre-interest $ 100Interest expense 100Taxable income $ 0Tax rate .50Foreign tax $ 0

Facts: Earnings repatriated via interest payments Total tax = $ 35 (Earnings taxed onceonce at

the U.S. rate)

Importance of Sourcing Rules

U.S. persons Taxed on worldwide income Foreign source income impacts

foreign tax credit limitation Foreign persons

Taxed only on U.S. source income

Maximizing the Foreign Tax Credit Limitation (§904)

Foreign tax Foreign source credit = Pre-credit X taxable income limitation U.S. tax Total taxable

income

How to increase the limitation?

Gross Income Recharacterize as foreign source income for U.S. tax purposes

Deductions Recharacterize as U.S. source

for U.S. tax purposes

Overview of the Sourcing Process Goal: Determine geographic origin of income Two step process similar to allocation and

apportionment of state income taxes Gross Income (§ 863 to § 865)

Step 1: Determine statutory category Step 2: Apply specific category rule

Deductions (Reg. 1.861-8) Step 1: AllocateAllocate to a related class of gross income Step 2: ApportionApportion based on factual relation of

deductions to gross income.

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 corporations

Dividends—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

Sourcing Rules—The General Rules (Continued)

Sale of Personal Property—Factors for Consideration Whether the property was produced by the seller. The type of property sold (e.g. inventory of capital asset) The residence of the seller

§865—Sale of Personal Property Other Than Inventory Sourced at the Residence of the Seller Gain on sale of depreciable personal property is sourced according

to the prior depreciation deductions to the extent of the deductions. An excess is sourced the same as the sale of inventory.

Gain on sale of intangibles is sourced according to prior amortization deductions to the extent of the deductions. Contingent payments are sourced as royalty income.

Gain attributable to an office or fixed place of business maintained outside the U.S. by a U.S. resident is foreign-source income

Sourcing of losses depends on the nature of the property (Reg. 1.861-8(e)(7))

Sourcing Rules for Inventory §§ 861(a)(6) & 865 Sale of purchased inventorypurchased inventory is sourced

in the country where the sale takes place. The sale is deemed to take place when title passes (Reg. 1.861-7(c))

When the seller produces produces the property the income must

be apportioned between the country of production and the country of sale.

Referred to as “§863 (b)” income” Seller must source the gross income under a 50/50

allocation method (see next slide) unless another method is elected.

Other methods are independent factory price and separate books and records.

50-50 Method for Sourcing Sales Apply to Gross Profit, 50% to Sales

and 50% to Property The sales factor:

Export sales where title passes abroad Total export sales

Definition of “export sales” –Goods produced in the U.S. and sold for use, consumption or disposition abroad

50-50 Method: The Property Factor

Average adjusted basis of foreign production assets

Average adjusted basis of all production assets

Denominator Includes assets used to produce inventory in the U.S. for sale

abroad Prorate assets used to produce inventory sold domestically and

abroad Excludes cash, receivables, inventory distribution and

marketing assets Average basis = (Beginning of year + end of year) ÷ 2

Numerator Assets in dominator that are physically located abroad Numerator equals $0 if taxpayer has no foreign manufacturing

facilities or owns foreign facilities through foreign subsidiaries.

Sourcing Gross Income under §861—Some Important Exceptions

Interest Income Certain interest received from a U.S. corporation that earned 80 percent

or more of its active business income from foreign sources over the prior three period is treated as foreign source income. [80/20 corporations]

Income received on amounts deposited with a foreign branch of a U.S. corporation is also treated as foreign source income

High withholding tax interest is treated as a separate basket for FTCL purposes

Dividends If 25% or more of a foreign 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 above Normally passive income for FTCL purposes, but special treatment for

CFC’s, 10/50 corporations, DISC’s and FSC’s..

§862 Income Sourced Outside the United States

Not as detailed or Specific as §861

If income is not U.S. source income, then it is foreign source income. §862 applies to the following:

Interest Dividends Compensation for personal services Income from the use or sale of property Other income

Source Rules for Deductions (Treasury Reg. 1.861-8)Step 1

Step 1: Allocation Potential Classes of Gross Income

Compensation for services Gross income from business Royalties Gains on dealings in property Interest Rents Dividends

Source Rules for Deductions (Treasury Reg. 1.861-8)Step 2

Step 2: Apportionment between U.S. and foreign source gross income

Potential Apportionment Bases

Gross income Gross sales Unit sales Cost of goods sold Profit contributions Expenses incurred Assets used Salaries paid Space used Time spent

Special Apportionment Rules Interest expense—see next slide Research and experimentation expenditures ordinarily are

considered to be definitely related to all income reasonably connected with the relevant broad product category and are allocable to all items of gross income as a class [i.e., sales, royalty, and dividend income] related to that product category. After allocation of the research expenses, the expense is apportioned between the statutory and residual groupings of income, using either the sales (50/50) method or the optional gross income method. (Reg. 1.861-17)

State income taxes are considered definitely related and allocable to the class to which the asset would normally generate gross income. (Reg. 1.861-8(e)(65)(i)

Net operating losses are allocated and apportioned in the same manner as the deductions giving rise to the NOL deduction. Reg. 1. 861-8(e)(8)

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. 1.861-8(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. 1.861-8(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. 1.861-8(e)(5)

Source Rules for Interest Expense

Fungibility principle Allocate interest to all gross income even if

borrowing relates to specific asset Apportionment base

Two methods available—fair market value or tax book value §864 (e)(2)

Affiliated groups Treated as a single corporation for purposes

of apportioning interest expense

Worldwide Effective Tax Rate—Why It is Important

Impact reported earnings

Impacts cash flow

Impacts evaluation of tax director

Examples of Impact of Foreign Operations on Effective Tax Rates

Caterpillar U.S. statutory rate 35.0%FSC benefit (3.2%)Other ` (1.2%)` Effective tax rate 30.6%

Exxon/Mobil U.S. statutory rate 35.0%Operations in high tax countries15.5% Other

(6.2%)Effective tax rate

44.3%

Pfizer U.S. statutory rate 35.0%Operations in low tax countries(5.5%)Operations in Puerto Rico(2.2%)Other (2.5%)

Effective tax rate24.8%

Planning for Foreign Operations by a U.S. Domestic Corporation

Goal: To minimize worldwide effective tax rate on foreign source income

U.S. tax on foreign income Deferral Foreign sales corporations and extraterritorial income

exclusion

Foreign taxes Reducing foreign taxes Maximizing allowable U.S. credit

Taking Advantage of Deferral—An Example

H ou sew are D is trib u to rs , In c . an d S u b s id ia ry

H ou sew are D is trib u to rs , L td .1 0 0 % ow n ed Irish su b s id ia ry

Irish ra te = 1 0 %

H ou sw ere D is trib u to rs , In c .U .S . P aren t

U .S . ra te = 3 5 %

Taking Advantage of Deferral--Continued Deferral = 25% residual U.S. tax Financial reporting: Can treat as

permanent difference that increases current earnings (APB 23)

Other examples of low tax countries: Singapore and Hong Kong

Restrictions on deferral Arm’s length transfer price Subpart F §367 outbound toll charge

Operating in High Tax Foreign Countries – Example

H ou sew are D is trib u to rs , In c . an d S u b s id ia ry

H ou sew are D is trib u to rs , P ty.1 0 0 % ow n ed Jap an ese m arke tin g su b s id ia ry

Jap an ese ra te = 4 8 %

H ou sw are D is trib u to rs , In c .U .S . P aren t

U .S . ra te = 3 5 %

Operating in High Foreign Tax Countries--Continued Problem: Excess foreign tax credits

Other examples of high tax countries: Canada and Germany

Planning: Increase allowable credits Reduce foreign taxes

Contract Manufacturing andCommissionaires—An Example

W orld co (U .S . p aren t) an d F ore ig n S u b s id ia ries

C on trac t M an u fac tu re r(F o ire ig n su b s id ia ry)

P rocesses com p on en t m ate ria lsin to fin ish ed g ood s

C om m iss ion a ire(F ore ig n su b s id ia ry)A c ts as sa les ag en t

fo r u n d isc losed p rin c ip a l, W orld co

W orld co , In c .(U .S . p aren t)

C on tro ls m an u fac tu rin g an d d is trib u tion o f p rod u c ts ,R esp on s ib le fo r m arke tin g th e p rod u c ts

Example (continued)--Commissionaire

Activities Acts as agent for undisclosed principal, Worldco

(contract is between commissionaire and customer) Worldco retains title until it passes to customer Worldco finances receivables and bears credit risk Marketing intangibles remain with Worldco

Tax consequences Commissionaire’s income reduced commensurate with

reduced responsibilities and risks Commissionaire’s income determined using cost-plus

approach Commissionaire does not create a permanent

establishment for Worldco

Example (continued)—Contract Manufacturer

Activities Processes component materials into finished

products under contract with Worldco Worldco retains title to inventory Profit and loss risk remains with Worldco Manufacturing intangibles remain with Worldco

Tax consequences Contract manufacturer’s income reduced

commensurate with reduced responsibilities and risks

Contract manufacturer’s income determined using cost-plus approach

Contract manufacturer does not create a permanent establishment for Worldco

Foreign Tax Reduction Planning—Holding Companies (Example)

Assume U.S. parent corporation R.S.A. subsidiary Dutch holding company R.S.A. makes dividend distribution to U.S. parent

Without the Dutch Holding Company The R.S.A. dividend subject to 25% withholding tax.

Dutch Holding Company The R.S.A. dividend subject to 5% withholding tax. The Dutch holding company dividend is subject to an

additional 5% withholding tax.

Foreign Tax Reduction Planning—Earnings Stripping

Debt financing for foreign subsidiaries Interest expense deduction in host country Possible reduction in foreign withholding taxes Possible increase in foreign tax credit

limitation(subject to CFC netting rule)

Transfer pricing and technology charges Inventory sales Technology charges Management fees

Foreign Tax Reduction Planning—Incentives in Local Tax Laws

Examples Ireland—10% rate for manufacturing Singapore—Tax holidays for high-tech

companies Puerto Rico—2% to 7% rate for

manufacturing Belgium—Special tax breaks for coordination,

service and distribution centers

Hybrid Entities

Classification of Foreign Entity

Foreign tax purposes, a corporation U.S. tax purposes, a partnership or

branch

A U.S. tax shelter?

Reg. 301.7701—The Check-the-Box Regulations

Effective date: January 1, 1997 Goal: Simplify entity classification New approach:

“Per se” corporations (e.g. U.K plc, German AG, French SA, Dutch NV) classified as corporations

For all other entities, taxpayers chooses classification via “check-the-box” procedure

Benefits: Enhances ability to use branches and partnerships in international tax planning

Tax Benefits of a Hybrid Entity

Avoids 10/50 company basket problems Allows flow-through of foreign losses, subject to dual

consolidated loss limitations Allows flow-through of foreign tax credits to S

corporation or partnership shareholders, a direct §901 foreign tax credit

Solves §902 multiple tier problems Avoids Subpart F through the use of “super” holding

companies and interest transfers from high tax country hybrid to a low tax country finance country hybrid

What is the next frontier of effective tax planning?

What is Transfer Pricing?H ou sew are D is trib u to rs , In c . an d S u b s id ia ry

H ou sew are D is trib u to rs , P ty.1 0 0 % ow n ed Jap an ese m arke tin g su b s id ia ryJap an ese ra te = 4 8 % , m arke tin g cos t = $ 1 5

R esa le o f p rod u c t to K orean cu s tom er fo r $ 1 0 0

H ou sw are D is trib u to rs , In c .U .S . P aren t, U .S . ra te = 3 5 %

E xp ort sa le o f G rill P ro tec to rs to su b s id ia ryM an u fac tu rin g cos t = $ 6 0

What is Transfer Pricing--Continued Houseware Distributors, Inc (Parent) must set an

appropriate transfer pricetransfer price for the sale of the grill protectors to Houseware Distributors, Pty. (the Japanese subsidiary).

Group profit = $25 ($100 - $60 - $15) Impact of alternative transfer prices:

Transfer price of $ 60 would allocate entire $25 profit to foreign subsidiary

Transfer price of $ 85 would allocate entire profit to U.S. parent

Transfer price between $ 60 and $ 85 splits the profit between the U.S. parent and the foreign subsidiary.

§ 482 Goal: Clearly reflect income of affiliated corporations

engaged in inter-company transactions. Standard: Arm’s-length price (or market value)

standard for evaluating transfer prices Practical difficulty: Market values are highly

judgmental and depend on the facts and circumstances.

Result: Transfer pricing is the most contentious area of audit and litigation controversy in international taxation.

Other observations: Many of the larger states have similar provisions to § 482.

Principal Factors for Assessing Comparability of Controlled and Uncontrolled Transactions—Reg. 1.482-1

Functions performed by the parties involved

Contractual terms governing transaction Risks assumed by each party Economic or market conditions in which

parties conduct business Nature of property or services

transferred in transaction

Transfer of Intangibles(Reg. 1.482-4)

H ou sew are D is trib u to rs , In c . an d S u b s id ia ry

H ou sew are D is trib u to rs , L td .1 0 0 % ow n ed Irish su b s id ia ry

Irish ra te = 1 0 %P ays ro ya lty to p aren t fo r u se o f p a ten t

H ou sw ere D is trib u to rs , In c .U .S . P aren t

U .S . ra te = 3 5 %G ran ts p a ten t rig h t to Irish su b s id ia ry

Transfer of Intangibles(Reg. 1.482-4)--Continued

ProblemNo comparables due to uniqueness of intangibles

Congressional responseCommensurateCommensurate with incomewith income requirement

Pricing methodsComparableComparable uncontrolled uncontrolled transactiontransaction method

ComparableComparable profits method profits method

Profit split methodProfit split method

Comparable Profits Method (Reg. 1.482-5)

1. Determine which affiliate will be the tested party.

2. Obtain data regarding comparable uncontrolled parties.

3. Choose profit level indicator, such as operating profit/sales or operating profit/operating assets.

4. Construct arm’s length range of comparable profits for tested party

5. Make adjustment if reported profit lies outside arm’s length range.

§662(e) Transfer Pricing Penalties

Rationale Promote more voluntary compliance with

arm’s length standard Promote better documentation of transfer

pricing policies 20% penalty applies if:

Transfer price 200% (or 50%) of arm’s length price (“transactional penalty”), or

Net §482 adjustment > either $ 5 million or 10% of gross receipts (“net adjustment penalty”)

§662(e) Transfer Pricing Penalties--Continued

40% penalty applies if: Transfer price 400% (or 25%) of arm’s

length price, or Net §482 adjustment > either $ 20 million or

20% of gross receipts Reasonable cause exception

To avoid net adjustment penalty, taxpayer must have created “contemporaneous” documentation

DHL Corporation, TC Memo 1998-481 IRS’s imposition of §6662 penalty upheld in court

How Should Taxpayers Respond?

Develop documentation that supports methodology and results Principal documents (§ 1.6662-6)

Nature of business Economic and legal environment Organizational structure Controlled transactions Pricing methods selected, rationale Comparables used Economic analysis and projections

Assess risk of transfer pricing adjustment Dollar magnitude of inter-company transactions Percentage of worldwide profits attributed to low-tax foreign

subsidiaries Consider transfer pricing study or Advance Pricing

Arrangement

Review—U.S. Taxation of Foreign SubsidiariesTax Jurisdiction

Excluded from U.S. consolidated return, can [by election] include Canadian and Mexican corporations in the group

Taxed only on U.S. source income

Profit Reparations U.S. parent can not claim the dividend received deduction U.S. parent can claim a §902 credit FTCL basketing rules: 10/50 company or CFC look-through

rule

Transfer Pricing Must use arm’s-length prices.

Shifting Income to a Foreign Base Company—An Example

H ou sew are M an u fac tu re rs , In c . an d S u b s id ia ries

H ou seh o ld M arke te r, P ty.1 0 0 % ow n ed Jap en ese m arke tin g su b s id ia ry Jap an ese R a te = 4 8 %

S ells g rill p ro tec to rs to Jap an ese re ta ile rP u rch ase cos t = $ 2 0 0 , S e llin g P rice $ 2 2 0

H ou seh o ld D is trib u to rs ,. L td .1 0 0 % ow n ed H on g K on g b ase com p an y H K ra te = 1 0 %

S ells g rill p ro tec to rs to H ou seh ou ld M arke tin g , P ty (Jap an )P u rch ase cos t = $ 6 0 , S e llin g P rice = $ 2 0 0

H ou sew are M an u fa tu re rs , In c .U .S . P aren t, U .S . ra te = 3 5 %

E xp ort sa le o f g rill p ro tec to rs to fo re ig n b ase com p an yM an u fac tu rin g cos t = $ 6 0 , se llin g p rice = $ 6 0

Anti-Deferral Provisions Concept

Deny deferral of “tainted” foreign earnings Simultaneously allow deferral for active

foreign business profits Specific regimes

Foreign Personal Holding Companies (enacted in 1937, “pocket book overseas”)

Subpart FSubpart F (enacted in 1962) Passive Foreign Investment Company

(enacted in 1986), discourages investment in foreign mutual fund companies

Subpart F (§§951-964), Controlled Foreign Corporations

CFC defined U.S. shareholders own >50% of stock, by

vote or value U.S. shareholder is a U.S. person that owns

10% or more of stock Subpart F inclusion (deemed dividend)

Subpart F income Investments in U.S. property

Subpart F Income (§§951-964) FTCL basket is determined by the type of income earned by the

subsidiary Foreign base company sales income

Income from the sale of goods Goods are purchased from or sold to a related person CFC neither manufactures the product or sells it for sells it for use in 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 income Fees for services performed outside CFC’s country of incorporation for a related

person. Insurance income

Income from insuring risks outside the CFC’s country of incorporation (i.e. lower risks)

Foreign personal holding income Passive investment income such as dividends, interest, rents, royalties and

capital gains Foreign base company shipping income Foreign base company oil-related income

Taxation of U.S. Shareholders

U.S. Shareholders Receive a “Deemed Dividend” from the Controlled Foreign Corporation

Year in which CFC has Subpart F Income U.S. shareholder is taxed on deemed dividend (§951) U.S. shareholder can claim §902 credit (§960) FTCL basketing rule: Same character as underlying

Subpart F income Actual dividend distributions in subsequent years (§959)

Traced first to CFC’s “previously taxed income” (PTI) Receipt of PTI is a tax- free return of capital

Earnings Invested in U.S. Property bythe Controlled Foreign Corporation (§956)

Concept: Constructive dividend of active foreign business profits

Treatment: Current inclusion under Subpart F

Transactions triggering §956 inclusions CFC makes loan to U.S. shareholders (includes

guarantees) CFC purchases stock issued by U.S. shareholders CFC purchases tangible property located in U.S. CFC purchases right to use intangible property is

U.S.

Form 5471 Information Return of a U.S. Person with Respect to a CFC

Who must file Shareholder of CFC

Contents Sch. A – Stock of CFC Sch. B – U.S. shareholders Sch. C and F – Financial statements Sch E, H and J – Foreign taxes and E&P Sch. I – Subpart F income Sch M – Inter-company transactions Sch. O – Changes in stock ownership

$ 10,000 penalty for failure to file TRA of 1997 added similar reporting requirements for

foreign partnerships controlled by U.S. persons

Foreign Personal Holding Company (§§551-558)

Concept: Incorporated pocketbook of wealthy U.S. citizens

Definition of FPHC 5 or fewer U.S. citizens own 50% or more of stock 60% or more of gross income is FPHC income

Deemed Dividend = Undistributed FPHC income

Passive Foreign Investment Company (§§1291-1298)

PFIC defined: 75% or more of gross income is passive

investment income or 50% or more of assets produce passive

income

Taxation of U.S. shareholders Qualified Electing Fund electionCurrent

taxation or Excess distribution: Pay deferred tax + interest

Review—Subchapter C Non-recognition Provisions

Concept Tax-free treatment of changes in legal form, but not

the underlying substance, of an investment Any appreciation not taxed currently is preserved for

taxation in the future through carryover basis Non-recognition Transactions

Incorporations (§351): Transfers of appreciated property to a controlled corporation

Subsidiary liquidations (§332): Transfer of appreciated property to parent corporation in complete liquidation

Reorganizations (§368 (a)(1)(A) and (a)(1)(D): Acquisitive (e.g., merger) and divisive (e.g., spin-off)

Illustration of Tax Avoidance Opportunities Created by Outbound Transfers to Foreign Corporations

U .S . p aren t & F ore ig n su b s id ia ry

F S U BF S U B se lls th e p rop erty to an u n re la ted p arty

Ig n orin g S ec . 3 6 7 , F S U B 's g a in is tax-free u n d er R eg . 1 .1 4 4 1 -2 (a )(3 )

U S PTran s fe rs ap p rec ia ted p rop erty to F S U B in exch an g e fo r F S U B s tock

Ig n orin g S ec . 3 6 7 , U S P 's ou tb ou n d tran s fe r is tax-free u n d er sec tion 3 5 1

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 sales Exception: Assets used in active active foreign business (§367(a)(3)

(A)) Exception does not apply to

Inventory, receivables, currency and intangibles (§367 (a)(3)(B)) Foreign branch with previously deducted losses (§367 (a)(3)(C)) To the extent of depreciation recapture on U.S. assets only (Reg.

1.367(a)-4T(b)) Reporting requirement: Form 926

Deemed Royalty Regime of §367(d)

U.S. parent transfers a patent to a foreign subsidiary, and receives a “deemed royalty”

“Deemed”

Actual Tax Attribute Royalty Royalty

Commensurate with income requirement Yes Yes

Foreign source income Yes Yes

Foreign tax deduction No Yes Foreign withholding taxes No Yes

(treaties, however, often provide exemption)

Illustration of Tax Avoidance Opportunities Created by Inbound Liquidation of CFC

Facts CFC distributes its accumulated E & P to

USP in liquidation U.S. tax consequences, ignoring §367

CFC’s earnings were not taxed currently (deferral privilege)

USP’s receipt of the distribution is tax free under §332

Any residual U.S. tax is permanently avoided

Deemed Dividend Regime of §367(b)

As a result of the CFC liquidation the U.S.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 stock

Good news: USP can obtain §902 credit with respect to any

dividend income

§367 Summary—Important to Consider the Source of the Property and Where It Ends Up

Code Section

Source/End Outcome

§367 (a) Start in the U.S. and ends overseas

Bad, unless exception

§367 (b) All inbound transactions

Good, unless bad

§367 (d) U.S. to Offshore(Intangibles)

Bad

Other Non-recognition Transactions Subject to a Toll Charge

U.S. corporation transfers appreciatedproperty to a foreign entity.. Outbound transfers to non-corporate entities

TRA 1997 added §721(c): Transfers to partnerships with foreign partners

Also added §684: Transfers to foreign estates and trusts

Expatriating liquidation of U.S. subsidiary into foreign parent

Other inbound and foreign-to-foreign transfers involving CFC’s

Overview of Inbound TransactionsA foreign corporation invests in U.S. assets

and receives U.S. source income. General Rules

Withholding tax regime for U.S. source non-business income (or “FDAP” (fixed or determinable, annual or periodic) [e.g. interest, dividends, rents, and royalties but not capital gains]

Net basis taxation on U.S. source business profits or “ ECI ” (effectively connected income)

Special Rules Treaty exemptions and reductions (e.g. UK 5% dividends,

0% interest and royalties Anti-earnings stripping rules (§163(j)) U.S. real property interests (§897) Branch profits tax (§884)

U.S. Taxation of Non-Business Income

General Rules Base = Gross amount of U.S. source income Statutory rate = 30% Collection via withholding by U.S. payer

Exceptions Capital gains Portfolio interest income (10%+ shareholders

excluded) U.S. real property interest Treaty withholding rates

W8 BEN available for non-resident aliens

Repatriating Profits from Domestic Subsidiaries

Goal: to minimize U.S. taxes (subsidiary-level and shareholder-level, and foreign taxes)

From the U.S. subsidiary perspective The issue is whether the remittance to the foreign

parent corporation creates a U.S. tax deduction From the foreign parent perspective

What is the U.S. withholding tax rate on the remittance?

Are foreign taxes owed on the remittance?

§163(j)--Anti-Earnings Stripping Provisions §163(j) applies to U.S. subsidiaries that have:

Debt to equity ratio in excess of 1.5 to 1 “Disqualified interest” payments, and “Excess interest” expense

Definition of “disqualified interest” Interest paid to a related party and exempt from

U.S. tax (or subject to reduced withholding tax rate)

Interest paid to unrelated party (e.g. U.S. bank), but guaranteed by related party (e.g. foreign parent) and exempt from U.S. withholding tax

Anti-Earnings Stripping Provisions (Continued)

Disallowed interest expense deductions are limited to the amount of excess interest

Definition of “excess interest” Net interest expense – 50% (adjusted taxable income) Net interest expense = interest expense – interest income Adjusted taxable income = Taxable income

+ Net interest expense

+ NOL carryovers

+ Depreciation expense

+/- Changes in receivables and payables

“Excess interest” is a cash flow concept Indefinite carry-forward of disallowed interest expense

deductions

Planning for Section 163 (j)

Remove foreign parent’s guarantee Reduce U.S. subsidiary’s debt-to-

equity ratio below 1.5 to 1 Increase U.S. subsidiary’s “adjusted

taxable income” without increasing taxable income

U.S. subsidiary should buy assets rather than leasing them.

Form 5472: Information Return of a Foreign-Owned U.S. Corporation

Who must file 25% foreign-owned domestic corporation Foreign corporation engaged in U.S. trade or

business Contents

25% foreign subsidiaries Other related parties Transactions with foreign related parties

Record maintenance requirements $ 10,000 annual penalty

Taxation of U.S. Real Property Interests

For foreign investors, gains on sale of U.S. real property interests are taxed like effectively connected income.(§897)

U.S. real property interests include: Land and buildings Mines, wells and other natural deposits Growing crops and timber Personal property “associated with” use of real

property such as fences and moveable equipment

U.S. Real Property Interests (Continued)

Foreign investors become shareholders in a U.S. domestic corporation which invests in U.S. real property.

U.S. real property holding corporations Market value of U.S. real property holdings 50% of

market value of all real property and business interests

Purchasers of U.S. real property interests Obligation to withhold 10% U.S. tax on amount

realized by foreign seller.

U.S. Taxation of Inbound Transactions

A foreign corporation receives ECI and/or FDAP Two-pronged system for taxing foreign

persons Passive foreign investors: Gross basis

withholding tax U.S. branch operations: Net basis on ECI

Focus here is on U.S. branch operations

Foreign Corporation Engaged in a U.S. Trade or Business

Nexus Per IRC: “Trade or business” within U.S. Per Treaty: “Permanent establishment” within U.S.

Tax base: Effectively connected income (§864(c)) U.S. source business income Selected types of foreign source business income Selected types of U.S. source non-business income Look back rules (10 years under §864(c)(7)

Tax rate schedule: same as domestic corporation

§884—The Branch Profits Tax—Rationale

Goal: Mimic U.S. withholding tax on dividends paid by U.S. subsidiaries (Comparison of # 1 with # 2)

1. The U.S. subsidiary pays the corporate level U.S. income tax and remits a dividend to the Foreign parent corporation. The dividend is subject to U.S. withholding tax at the shareholder level.

2. The U.S. branch pays the corporate level U.S. income tax and remits a dividend equivalent amount to the Foreign parent corporation. The dividend equivalent amount is subject to the branch profits tax.

Computing the Branch Profits Tax

Need formula for estimating dividend equivalent amount

Under §884 (b) (A) Effectively connected E & P for the year(B) + Decrease in “ U.S. net equity”

(deemed distribution to foreign home office)or

- Increase in “U.S. net equity” (deemed reinvestment in U.S. branch)

= Dividend equivalent amount

- Tax rate = 30% statutory rate subject to treaty reductions

- Some Treaties eliminate the amount

Branch Profits Tax– An Example (Year 1)

Year 1 Treaty rate on dividends (controlling shareholder) = 5 % Effectively connected E & P = $ 100 U.S. net equity: $1,000 at beginning of year

$1,100 at end of year Branch profits tax calculation:

Effectively connected E & P $ 100Increase in U.S. net equity:

Beginning of year $ 1,100End of year 1,100 (100)

Dividend equivalent amount $ 0 x 5%

Branch profits tax $ 0

Branch Profits Tax: An Example (Year 2)

Year 2 Treaty rate on dividends (controlling shareholder) = 5 % Effectively connected E & P = $ 100 U.S. net equity: $1,000 at beginning of year

$1,100 at end of year Branch profits tax calculation:

Effectively connected E & P $ 0Decrease in U.S. net equity:

Beginning of year $ 1,100End of year 1,060

40Dividend equivalent amount $ 40

x 5%Branch profits tax $ 2

§884 (f)—Branch Interest Withholding Tax

What is it? 30% withholding tax on “interest payments” Tax imposed on foreign payee, not the U.S. branch Creates tax parity between U.S. tax imposed on

interest payments made by U.S. branches and U.S. subsidiaries

Computation of tax: Reg. 1.884-4 defined “interest payment” Statutory exemptions (e.g. portfolio interest

exemption) and reduced withholding rates apply

§884(f)--An Additional Provision, The Excess Interest Tax

What is it? 30% tax on U.S. branch’s excess interest Tax is imposed on U.S. branch, not the recipient of the interest

payment Recapture provision designed to create symmetry between

interest deductions and related interest income inclusionsComputation of tax: Excess interest = Interest expense deducted in computing

“Effectively Connected Income” (per §1.882 -5)

minus “Interest payments” subject to

branch interest withholding tax [See Preceding

slide] Reduced treaty withholding rates apply