Transcript None - Texas Tech University

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

U.S. INTERNATIONAL TAX FRAMEWORK
(CONT’D)
Type of Person
U.S.
US Source Income
Taxed in U.S.
Foreign
Foreign Source Income
Taxed in both U.S. and
foreign jurisdiction
Foreign Tax Credit
allowed
“Outbound”
US Source Income
Potentially Taxed
in U.S.
“Inbound”
Foreign Source Income
Generally taxed only in
foreign jurisdiction
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

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
TAXATION OF U.S. PERSONS WITH FOREIGN
INCOME: “OUTBOUND” TAXATION
Foreign source investment income
• US income tax
• Local country withholding tax
USCo
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
US
Corporation
(35% tax)
$600 Foreign Source Net Income
(subject to tax in both the US and
foreign jurisdiction)
Foreign
Branch
(30% tax)
US Corporate Tax Return – Form 1120
US TAXATION – ASSUMING NO FTC OR
DEDUCTION FOR FOREIGN TAXES
US Tax Return
US Source Income
Foreign Source Income
Taxable Income
Foreign Country Tax Return
$1,000
Foreign Source Income
$600
Taxable Income
$600
600
$1,600
x .35
US Income Tax
US Tax
Foreign Tax
Worldwide Tax
Worldwide ETR
$ 560
x .30
Foreign Income Tax
$560
180
$740
46.25% [$740/$1,600]
$180
US TAXATION – WITH DEDUCTION FOR
FOREIGN TAXES
US Tax Return
US Source Income
Foreign Source Income
Deduction for Foreign Tax
Taxable Income
Foreign Country Tax Return
$1,000
US Tax
Foreign Tax
Worldwide Tax
Worldwide ETR
$600
Taxable Income
$600
600
-180
$1,420
x .35
US Income Tax
Foreign Source Income
x .30
Foreign Income Tax
$ 497
$497
180
$677
42.30% [$677/$1,600]
$180
US TAXATION – WITH FTC
US Tax Return
US Source Income
Foreign Source Income
Taxable Income
Foreign Country Tax Return
$1,000
Foreign Source Income
$600
Taxable Income
$600
600
$1,600
x .35
US Income Tax (before FTC)
$ 560
Less FTC
-180
US Income Tax (after FTC)
$380
US Tax
Foreign Tax
Worldwide Tax
$380
180
$560
Worldwide ETR
35%
x .30
Foreign Income Tax
[$560/$1,600]
$180
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

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?
GOING GLOBAL OVER TIME
Time
Domestic
Operation Only
Export
License to
Foreign Person
Current U.S. Taxation
Foreign Branch
or Partnership
Separate
Foreign Entity
Potential Deferral
FORMS OF DOING BUSINESS AND THE U.S. TAX
EFFECTS
Type of Entity
US Taxation?
Timing of US Taxation
Export
Full
Current inclusion
License
Full
Current inclusion
Branch
Full
Current inclusion
Partnership
Full
Current inclusion
Foreign Corporation
Only upon repatriation
or deemed inclusion
Deferral (but Subpart F,
956 income, and other
provisions may require
current inclusion)
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
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
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
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
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
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
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/Terminatio
n 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
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”
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
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


Services


Intercompany loans, accounts receivable, guarantees
Management fees, potential transfer of intangibles
Intangibles

Royalties, cost sharing, buy-in payments, sale of intangible
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


Gross Valuation Misstatement


20 percent of additional tax
40 percent of additional tax
Treas. Reg. §1.6662-6
INTRODUCTION TO
INTERNATIONAL TAXATION
Foreign Tax Credit
PwC
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 - §§901 - 907
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. §1.901-1(d) and §6511

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)
TYPES OF FOREIGN TAX CREDITS



Direct credit - §901
“In lieu of” credit - §903
Deemed paid (indirect) credit - §902 and §960
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

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)
FTC LIMITATION FORMULA - §904

Foreign
Tax
Credit
Limit
=
Foreign Source
Taxable Income
Within Basket
x
Total Taxable Income
US Tax
Before FTC
Allowed FTC is the lesser of:
 Creditable foreign income taxes -§§901 –
903
 FTC limit - §904
 See Form 1118

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

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. §1.901-2

REQUIREMENTS OF A CREDITABLE TAX
(CONT’D)

Reg. §1.901-2(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]
REQUIREMENTS OF A CREDITABLE TAX
(CONT’D)

Realization test - Reg. §1.901-2(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. §1.901-2(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

REQUIREMENTS OF A CREDITABLE TAX
(CONT’D)

Net income test - Reg. §1.901-2(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


Taxes paid to “§901(j) countries”


Any benefit conferred, directly or indirectly, by the foreign
country to the taxpayer - Reg. §1.901-2(e)(3)(ii)
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. §1.901-2(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
Foreign Tax
1,000€
$ 250
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
Sub
Foreign Income
Foreign Tax
Foreign E&P
1,000€
$ 250
750€
Assume $1 : 1€
FTC - DEEMED PAID TAX CALCULATION

Dividend* or
“Deemed Dividend”*
Post-86 Undistributed
Earnings
Functional Currency

* before §78 gross-up
Post-86 Foreign = §902 FTC
x Tax Pool
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)
Sourcing Income and Expenses
PURPOSE OF SOURCING RULES
Gross Income
Sourcing Rule
PURPOSE OF SOURCING RULES (CONT’D)
Gross Income
Sourcing Rules
Deductions
Allocation & Apportionment
SOURCING IMPLICATIONS – U.S. PERSONS
Determination of FTC limitation - §904
FTC Limitation = Foreign Source Taxable Income x U.S. Income Tax
Before FTC
(within Basket)
Total Taxable Income
U.S. FRAMEWORK FOR SOURCING GROSS
INCOME
Predominant Situs
Residence of
Recipient
Split Source
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
Step #2
Determine
gross
income
category
Apply
category
specific
source rule
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)
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)]

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.§1.861-4(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.§1.861-18
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


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 50-50 method - Reg. § 1.863-3
 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. § 1.861-8
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. §1.861-8(a) and (b)
 A deduction may be definitely related to all of the
taxpayer’s gross income - §1.861-8(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.§1.861-8T(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.§1.861-8(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.§1.861-8T(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.§1.861-8T(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.§1.861-8(c)(3)
Examples include
Real estate taxes on a personal residence
 Medical expenses
 Charitable deductions
 Alimony
 See Reg. §1.861-8(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.
§1.861-17
 This apportionment is required without regard to
where the R&D activity is performed

FTC Limitation
FTC FORMULA: SEPARATE BASKETS

Foreign
Tax
Credit
Limit
=
Foreign Source
Taxable Income
Within Basket x
Total
Taxable Income
US Tax
Before FTC
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
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

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

INTRODUCTION TO
INTERNATIONAL TAXATION
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--NonDiscrimination
 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
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
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. 90-80; 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 5 - 10%
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
INTRODUCTION TO
INTERNATIONAL TAXATION
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
MIGRATION AND DEFERRAL
Migration
& Deferral
Strategies
New Plants
Tax-Favored
Locations
Commissionaire
and Strip-Risk
Marketing
Flexible and
Effective
Transfer Pricing
Policy
R&D
Cost-Sharing
Low-Taxed
Trading
Companies
Tax-Favored
Legal Structure,
Including
Holding Companies
Contract
Manufacturing
Low Profit
Functional
Service Centers
APB 23
FINANCE AND RISK MANAGEMENT
Finance & Risk
Management
Strategies
Creating Debt
Through
Intercompany
Asset Sales
Tax- Advantaged
Leasing
Formal
Capital
Reductions
Captive
Insurance
Companies
Risk Management
& Financial
Products
Factoring of
Receivables
Optimize
Cross-Border
Withholding
Taxes
Dividend
Strips
Hybrid
Instruments
Treasury
& Cash
Management
Capital Loss/Gain
Strategies
Export
Incentive
Enhancement
JURISDICTIONAL
Jurisdictional
Strategies
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
Lobbying for
Reduction in
Cross-Border
Withholding Taxes
Promoting
Favorable
Tax Treaties
FASB
Initiatives
(APB 23, etc.)
Protecting Tax
Favored Treatment
of Income Sources
and Taxation
WTO
Initiatives
Maintaining
Incentives
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
740 - 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)
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