Transcript Document
Taxation of Inbound
Transactions
Recall definition of an inbound
transaction
Two taxing regimes:
Passive investment income
• 30% tax on gross income (many exclusions)
• Tax withheld by payor
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Income ‘effectively connected’ with a US
‘trade or business’
• Net income taxed under graduated rates
• US tax return required
Passive Investment Income
‘Fixed or determinable’ income
Taxed under the passive investment rules
if not ‘effectively connected income’
Interest, dividends, rents, royalties,
annuities, prizes, found money, etc.
All gross income measurable by the payor
Wages, salaries, other compensation are
‘fixed and determinable’ but are often also
‘effectively connected income’
Gains from property sales not included
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Investment Income
Excluded from US Taxation
US source interest income
Deposits in US financial institutions
Portfolio interest
• Interest on debt held by identifiably foreign
persons
• Interest paid on any obligation either
• In registered form with a foreign owner, or
• If in bearer form, issued with restrictions on US
ownership
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Exceptions to Nontaxability
of Interest Income
US-source interest received by ‘10percent shareholder’ of the issuer is
subject to flat tax
10% or more of combined voting power
10% or more partner in a partnership
Attribution rules apply in determining
ownership
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Example 1: Investment
Interest Exclusion
In each case below, is interest earned by
Guy, a foreign person with no ‘effectively
connected’ income, subject to US tax?
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Guy earns $200,000 of interest from deposits of
funds held in US banks
What if the interest was paid by a US corporation
of which Guy is not a shareholder?
What if Guy owns 1% of the US corporation’s
outstanding common stock? 10%? 50% of its
nonvoting preferred stock?
What if the interest is paid by a foreign
corporation?
Example 2: Planning without
the 10% Shareholder Rule
Kim, a foreign person with no ‘effectively
connected’ income, wishes to invest in a US
business
What are Kim’s tax consequences without
the 10% shareholder rule? With the rule?
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She forms a corporation to buy the US business
The business issues Kim 1 share of common
stock and bonds with a face amount of $1 million
paying 12% interest
Does it matter if the corporation is a US
corporation or a foreign corporation?
Other Exceptions to Nontaxability of Interest Income
US-source interest income of foreign
banks on the extension of credit in the
ordinary course of its trade or business
Contingent interest based on
Sales, receipts, cash flow, income, or
profits of the debtor
Change in value of property of the debtor
Dividends or similar payments by the
debtor
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Income from Intangible
Property
Royalties considered ‘fixed or
determinable’ and sourced to country
of use of the property
Income from sale of intangible
property sourced to residence of seller
Sale versus license
Sale must transfer all substantial rights
Contingent payments treated as royalties
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Trade or Business
Direct ownership of income-producing
property with related risks and
responsibilities
Ownership of rental real estate and
mineral interests may or may not
qualify
Depends on level of owner’s control and
involvement in operations
Can elect to treat income as ‘effectively
connected’
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Example 3: Rental Income
Li, a foreign person, owns rental real
estate generating $200,000 of rental
income per year on which he pays
$120,000 of expenses
If Li’s rental activities are not considered a
trade or business, how will he be taxed?
Should Li elect to treat his rental activity
as effectively connected? Why or why
not?
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Other Trade or Business
Activities
Income from performing services
Income from sale of inventory
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But not income from sale of investment
assets
Income from manufacturing
US Trade or Business
Requires economic activity in the US,
but no clear threshold as to how much
presence is a ‘US trade or business’
Insufficient activity includes
• Promotional activity alone
• Purchase of goods in US for sale elsewhere
• Sales through independent contractors/brokers
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US trade or business can be imputed
between agent and principal, from
partnership to partners
‘Effectively Connected’
Income
Only a foreign person who at some
time has been engaged in a US trade
or business can have effectively
connected income
US source ‘fixed or determinable’ income
and capital gains may be effectively
connected under two tests
• ‘asset use’
• ‘activities’
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‘Effectively Connected’
Income continued
‘Asset use’ test
‘Activities’ test
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Income from the use of assets is effectively
connected if the rental operation is a trade or
business
Interest income is effectively connected if earned
on funds supporting current business operations
Income is effectively connected if the ‘activities’
of the business are a ‘material factor’ in its
realization
Captures income from performance of services
Other ‘Effectively Connected’
US Source Income
All other US source income of a foreign
person engaged in a US trade or
business is ‘effectively connected’
Includes sales of inventory and other US
source business profits
Applies beyond US source income directly
from the US trade or business in which the
foreign person is engaged
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Example 4: Other US Source
Income
Euro Inc., a foreign corporation with no
permanent US place of business,
manufactures products sold by mail to
US catalogue customers
Is Euro’s income from such sales
‘effectively connected’?
Now suppose Euro opens a store in NYC.
Is income from the store ‘effectively
connected’? What about income from the
catalogue sales?
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‘Effectively Connected’
Foreign Source Income
If a foreign taxpayer has an office or other
fixed place of business in the US (directly or
through a dependent agent), certain foreign
source income of that business is considered
‘effectively connected’
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Rents and royalties for the use of intangible
property outside the US
Financial gains from a US banking business or
active securities investment company
Gains from the sale ‘through’ the US office of
inventory, unless sold for use outside the US and
a foreign office of the taxpayer participates
materially in the sale
Example 5: Foreign Source
Income
Recall example 4 in which Euro sells
products by mail to US customers
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Would the treatment of income from these
sales change if Euro establishes a sales
office in NYC to market its products, which
are still manufactured and shipped from a
foreign country?
Sale of US Real Property
Gains/losses of foreign persons from
sale of ‘US real property interests’ are
considered ‘effectively connected’ with
a US trade or business
‘US real property interest’ includes
• Direct interest in real property located in the
US or the US Virgin Islands
• Interest in a ‘US real property holding
company’ (USRPHC)
• Does not include less than 5% ownership of
stock in a publicly traded US corporation
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Real Property
Land, buildings
Mineral deposits, natural resources
All permanent structures on land
Structural components
Furnishings and other personal
property associated with the use of the
real property
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‘Interests’ in Real Property
Fee ownership, co-ownership,
leasehold, options
Interest in any domestic corporation
qualifying as a USRPHC at any time
during the shorter of
The period of time the interest was held
by the foreign person, or
Five years ending on the date of
disposition of the interest
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USRPHC
Any corporation for whom the FMV of
its US real property is 50% or more of
the FMV of its combined worldwide real
property and assets used in the
conduct of a trade or business
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Passive investment assets not included in
this test
Example 6: USRPHC
Rap Inc. owns assets with the following
values on 1/1/2002:
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US real property
$4 million
Foreign real property
2 million
Foreign business assets 1 million
Investments
2 million
Is Rap a USRPHC?
If Ted, a foreign person, sells his 10%
interest in Rap during 2002, how will any
gain or loss be treated for US tax purposes?
Example 7: Interest in
USRPHC
Refer to Example 6. Suppose that the
value of Rap’s foreign assets increases
to $5 million by 1/1/2003.
How long would Ted need to wait before
selling his stock in order to avoid US
taxation?
If Joan, another foreign person, buys Rap
stock on 2/1/2003, and sells it on
12/31/2003, how will her gain or loss be
treated for US tax purposes?
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Foreign Corporations Owning
US Real Property
An ownership interest in a foreign
corporation owning US real property is
not a US real property interest
Sales of such shares will not trigger
‘effectively connected’ income
However, when the foreign corporation
sells the real estate, it has sold a US real
property interest and is taxed on the gain
in the US
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