Transcript Lovely Professional University Lecture 2. Global Business – Global Finance and Tax Planning Howard Godfrey, Ph.D., CPA Professor of Accounting Copyright © 2010

Lovely Professional
University
Lecture 2.
Global Business –
Global Finance
and Tax Planning
Howard Godfrey, Ph.D., CPA
Professor of Accounting
Copyright © 2010
1
Profile of
Multinational Businesses
Subject to U.S. Tax Law –
Part I. Inbound Investments
By Howard Godfrey and Casper Wiggins
Investing in Charlotte
Note: some foreign investors
simply buy stock in U.S.
corporations or invest in mutual
funds. We are not considering
those types of investments in this
presentation. We focus on a more
direct ownership of business
operations.
3
Investing in Charlotte
A corporation or an individual investor
in India wants to invest in the United
States and take advantage of the
expected recovery from the recession.
What are some alternative ways to
invest?
Which these would be appropriate for
the new business mentioned in the
first presentation: India-in-Charlotte?
4
Foreign investors expand into
the U.S. with inbound
investments.
Inbound investments include:
1. buying or organizing U.S.
subsidiary corporations,
2. operating U.S. branches,
3. investing in partnerships that
have U.S. business operations,
4. investing in U.S. real estate.
Investing in Charlotte
Each of the four types
of investments on the
preceding slide has its
own set of tax issues.
6
U.S. investors may also choose to
expand business operations in
foreign countries with outbound
investments that follow the same
patterns.
This paper (Part I) focuses on
multinational businesses with
inbound investments, i.e., foreign
investors with business operations
in the U.S.
Over 60,000 U.S. corporations are
foreign controlled.
Foreign investors also have about
15,000 U.S. branches in the United
States, and
about 7,000 foreign partnerships report
U.S. source income on annual U.S.
partnership tax returns.
Foreign investors' equity interest in
(and loans to) U.S. affiliates grew at the
rate of 14% to $2 trillion in 2007.
On the outbound side, about 11,000 U.S.
corporations have over 75,000 foreign
subsidiaries with assets of about $10 trillion
and net income of about $400 billion.
Individuals reported foreign income on 7.6
million individual tax returns for 2006
and claimed foreign tax credits of $11 billion
for foreign income taxes paid on foreign
source income.
U.S. owned equity in (and loans to) foreign
affiliates reached $2.8 trillion at the end of
2007, an increase of 14% over 2006.
Note for the next slide
A U.S. Corporation opens a branch in India.
The Corporation has net income in India of
$100,000.
Assume India has a 30% income tax rate
and the company pays Indian income tax of
$30,000.
Assume the U.S. has a 40% income tax rate
and the company pays U.S. income tax of
$40,000.
Is the global tax burden equal to $70,000?
How Tax Credits Work
Incomein India
U.S.
India
Total Tax
by U.S. business $100,000 $100,000
Tax Rates
40%
30%
Gross US. Tax
$40,000
$40,000
Gross India Tax
$30,000
$30,000
Gross Tax
$70,000
U.S. Gross Tax
Credit for India Tax
Net U.S. Tax
How Tax Credits Work
Incomein India
U.S.
India
Total Tax
by U.S. business $100,000 $100,000
Tax Rates
40%
30%
Gross US. Tax
$40,000
$40,000
Gross India Tax
$30,000
$30,000
Gross Tax
$70,000
U.S. Gross Tax
Credit for India Tax
Net U.S. Tax
$40,000
($30,000)
$10,000
In 2007, foreign persons invested $277
billion to acquire interests in U.S.
businesses or to start new businesses here.
Most of this investment (92%) was for the
acquisition of existing U.S. firms.
U.S. corporations that have foreign owners
are termed foreign-controlled domestic
corporations (FCDC’s).
They (FCDCs) have essentially the same
requirements for filing corporate income tax
returns and paying taxes as other domestic
corporations.
Investing in Charlotte
What is the income tax
filing and payment
procedure for
India-in-Charlotte, Inc.?
(covered in preceding lecture)
14
Number and Importance of FCDCs
For tax years ending between July, 2005
and June 2006, 61,820 corporate income tax
returns were filed by U.S. corporations that
were foreign controlled. These FCDCs had
total receipts of $3.5 trillion and assets of
$9.2 trillion.
They paid U.S. income tax of $42.4 billion.
Almost 10% (5,736) were consolidated
returns. This indicates that the number of
U.S. corps under control of foreign persons
is substantially larger than 61,820.
Seagate Technology designs, manufactures
and sells computer hard drives. Seagate
headquarters are in the Cayman Islands
which has a zero income tax rate.
U.S. executive offices are in California.
Principal manufacturing facilities are
located in China, Malaysia, Northern Ireland,
Singapore and Thailand and, in the United
States, in California and Minnesota.
The Company’s Form 10-K for fiscal year
ended June 27, 2008 disclosed that it has
twelve subsidiaries in the U.S. and 61
subsidiaries world-wide.
Seagate Technology
How is Seagate
Saving Income Tax
by not being a
U.S. Corporation?
Seventy percent of FCDC receipts were
reported by FCDCs with parents in five
countries. Twenty percent of all
receipts of FCDCs were reported by UK
owned subs in the U.S., followed by
Japan (16%), Germany (12%),
Netherlands (12%), and Canada (8.7%).
Although Canada and Mexico are
major trading partners with the U.S.,
there are fewer U.S. subsidiaries with
parents in those countries.
Profitability of FCDCs
FCDCs are less profitable than their nonforeign controlled competitors in the U.S.
Manufacturing FCDCs reported gross profit
of 21.5% of gross receipts, while large nonforeign controlled manufacturers reported
average gross profit rates of 27.5%, a 6%
difference.
FCDCs in wholesale and retail sales had
gross profit rates of 19.3% (23% for their
non-foreign controlled counterparts). Gross
profit is business receipts less cost of sales.
Role of Intercompany Transactions-1
The global income tax
burden of a parent and
subsidiary corporation can
be managed when one entity
is in a high tax (i.e. income
tax) country and the other
entity is in a low tax country.
Role of Intercompany Transactions-2
A parent corp. (in a low tax country)
may increase the price it charges the
subsidiary (in a high tax country) for
inventory. This decreases the amount
of income reported in the high tax
country such as the U.S., and
increases the amount of income
reported in the low tax country. Global
tax liability is reduced by a change in
the intercompany pricing policy.
India-in-Charlotte
Please take a look at the
financial information handed
out for India-in-Charlotte.
What transfer pricing issues
may be present for this
company?
22
Case-2006-IRS settlement with GSK
over transfer pricing issues for tax years
1989-2005. GSK agreed to pay a record
amount of $3.4 billion to the IRS. The IRS
position was that GSK understated its U.S.
profits. Transfer pricing issues related to
trademarks & other intangibles developed
by company’s U.K. parent, and the value of
GSK’s marketing and other contributions in
the U.S. IRS stated, “Transfer pricing that
allocates an appropriate return to the U.S.
affiliates of multinational groups is a key
focus for the IRS.”
Purpose of Form 5472.
Congress was concerned about the
potential for using intercompany
transactions to shift taxable income to
other countries.
For this reason, Section 6038A was
added to the Code, which requires
extensive record keeping and reporting
of information about intercompany
transactions with foreign related
parties.
Form 5472 is used for
reporting of intercompany
sales & purchases of
inventory and other assets,
intercompany rent payments,
insurance premiums,
commissions, loans, interest
payments, etc.
Form 5472 must be filed by a
“reporting corporation” which is a
domestic corporation and is at any
time during the year a 25-percent
foreign-owned entity. The reporting
corporation provides information
about intercompany transactions
with a 25-percent foreign owner
and other parties that are related.
Case. Foreign Partnership (FP) owns 100
percent of U.S. Corp (USC), and 25 percent
of Foreign Corp (FC). The remaining 75
percent of FC is publicly owned by many
small shareholders. Sales transactions
occur between USC and FC. USC is a
reporting corporation. USC and FC are each
controlled by FP under section 482 and the
related regulations.
Therefore, FC is related to USC within the
meaning of section 482 and is a related
party to USC. Sales transactions between
USC and FC are subject to section 6038A.
Importance of Form 5472.
A reporting corp. is required to file
Form 5472 with its income tax return
for the taxable year by the due date
(including extensions) of that return.
If a reporting corp fails to file the Form
5472 within the prescribed deadline,
the reporting corp may be assessed a
monetary penalty of $10,000 for each
taxable year for which such failure
occurs.
Transactions of Large FCDCs with Related
Foreign Persons. In 2004, transactions
(other than loans) between large foreign
owned domestic corps and related foreign
parties reached $1 trillion. Large FCDCs
filed 774 corp income tax returns, with large
corp being defined as those with total
receipts of $500 million or more. These
large corps account for about 75% of all
assets and all receipts of the entire
population of FCDCs. FCDCs file about
16,600 forms (Form 5472) with their income
tax returns.
29
Sales and purchases of
inventory accounted for 86%
of the non-loan intercompany
transactions. Large FCDCs paid
$608 billion to foreign related parties
for inventory and received $371 billion
for sales of inventory to those parties.
Large corps owed foreign related
parties a total of $307 billion at the end
of 2004, and paid interest of $26 billion
to foreign related parties.
30
Information on Form 5472
provides the IRS with a basis
for challenging intercompany
pricing for sales of inventory,
interest rates charged, fees
paid for managerial services,
royalties for use of
intellectual property, etc.
31
Withholding on Dividends & Interest
U.S. individuals or businesses making
payments of U.S.-source income to foreign
persons withhold taxes on this income
(except where there is an exemption created
by statute or treaty), or to appoint a
withholding agent to manage the process.
Financial institutions often serve as
withholding agents. Interest and dividends
are two important types of such payments.
Foreign corporations receive most of the
payments of U.S source income.
32
Withholding on Dividends & Interest
Amount of income paid to each
recipient is reported on Form 1042S.
A payer is liable for all withholding
taxes owed on such payments.
The standard income tax withholding
rate is 30%, but the withholding rate on
certain types of income may be
reduced (possibly to a rate of zero)
because of a treaty with the country of
residence of the recipient.
33
Withholding on Dividends & Interest
Amount of Withholding on U.S. Source
Income Paid to Foreigners. In 2006, 3.7
million withholding Forms 1042S were filed,
reporting a total of $545 billion in payment
of U.S. source income to foreign recipients.
Taxes of $8.4 billion were withheld on
payments of $69 billion which were subject
to withholding. The balance of the $476
billion was not subject to withholding,
typically because of provisions of tax
treaties with applicable countries.
34
India-in-Charlotte
Please take a look at the
financial information handed
out for India-in-Charlotte.
What withholding issues may
be present for this company
related to dividends paid to
owner in India?
35
India-in-Charlotte-Continued
What is the impact
of a treaty with India
(on tax
withholding)?
36
Case. Seagate Technology
designs, manufactures,
markets and sells
computer hard drives.
Seagate is a holding
company in the Cayman
Islands which has a zero
income tax rate.
37
Case. Seagate Technology.
Form 10-K for the fiscal year
ended June 27, 2008 disclosed
that dividend distributions
received from the Company’s
U.S. subsidiaries may be
subject to U.S. withholding
taxes when, and if, distributed
to the Cayman parent.
38
Case. Seagate Technology.
The Cayman Islands holding
company would not incur
U.S. federal income tax if it
receives dividends from U.S.
subsidiaries, and would incur
no Cayman Islands income
tax on such dividends.
39
Case. Morgan Pacific Corp. was
formed as an Oregon (U.S.) corp.
Both Morgan Pacific Corp. and
Mid-Coast Finance (a Netherland
Antilles corp.) were controlled by
Jay Holdings, a Jersey, Channel
Islands corporation.
Morgan Pacific made an interest
payment of $455,000 on its debt of
$4,550,000 to Mid-Coast.
40
Case. Morgan Pacific Corp.
Morgan Pacific did not withhold
income tax on the interest
payment because a U.S. treaty
with Netherlands Antilles
provided that no U.S. income
tax would be withheld on
payments of interest to
residents of that country.
41
Branch Return on Form 1120-F
A foreign corporation may choose operate
as a U.S. branch rather than to buy or
organize a domestic corporation when
expanding into the United States. If a
foreign corporation operates a business
through a branch in the U.S., the foreign
corporation is subject to U.S. tax on income
“effectively connected” with the conduct of
a U.S. trade or business in a manner similar
to that used to tax domestic corporations.
42
Branch Return on Form 1120-F
Form 1120-F is a U.S. income tax
return filed by foreign corporations
that: (1) engage in a trade or business
in the U.S., (2) have income, gains or
losses that are treated as being
effectively connected with a U.S.
business, or (3) have U.S. source
income and the liability for U.S. tax on
that income has not been satisfied
through a withholding tax.
43
Branch Return on Form 1120-F.
A domestic corporation is
organized in the United States.
A branch is not incorporated in
the United States, although the
company may be incorporated
in a foreign country.
44
Review
Which of the
charlotte area
businesses (with
ownership in India)
is a branch?
45
Number and Importance of Branch Returns
In 2006, 14,897 foreign corps
filed Forms 1120-F. They paid
U.S. income tax of $3.2 billion
on income effectively
connected with the U.S., and
about $141 million on other
income such as interest income
received from the U.S.
46
Number and Importance of Branch Returns
They paid branch profits tax of
about $83 million. This is the
counterpart of the withholding tax
on dividends paid by U.S.
subsidiaries to their foreign parent
corps or other foreign persons.
Branch profits tax rate is 30%, but
may be reduced by treaty, possibly
to zero.
47
File Form 1120-F on Time
A foreign corporation that
fails to file Form 1120-F
on a timely basis loses
the right to claim most
deductions on the return.
Reg. Sec. 1.882-4(a)(3)(ii)
48
Partnership Withholding Requirements
A domestic or foreign partnership is
subject to withholding tax
requirements when it:
(1) has taxable income from a U.S.
business operation (called
effectively connected taxable
income or ECTI) and
(2) some of that income is allocated to
a foreign partner.
49
Partnership Withholding Requirements
If the foreign partner is an
individual, the withholding rate is
the highest individual income rate.
The highest corporate income tax
rate applies to other types of
partners. These withholding
requirements do not apply to
amounts allocated or paid to U.S.
partners.
50
When foreign partner files a U.S.
income tax return for the year and
reports U.S income, a credit is allowed
for the withholding tax. A foreign
partner may file Form 8804-C to reduce
the amount of required withholding (or
possibly eliminate the withholding
requirement), when the foreign
partner's U.S. income tax liability will
be less than the standard withholding
amount.
51
Importance of Partnership Returns
A partnership return must be filed
by a domestic partnerships and a
foreign partnership that engages in
a business in the U.S. or has
income from sources in the U.S.
The IRS receives about 3 million
partnership returns each year
covering about 16.7 million
partners.
52
Importance of Partnership Returns
About 7,000 of those are foreign
partnership returns covering
181,000 foreign partners. Corp.
partners receive the largest
amount of income allocations
from partnerships, followed by
individual partners, partners
that are partnerships, etc.
53
Review
Would the
partnership form be
applicable for
India-in-Charlotte?
Please Explain.
54
U.S. Partners of Foreign Partnerships
A U.S. person files Form 8865 with
respect to foreign partnerships (when
the U.S. person owns a controlling
interest in the foreign partnership,
contributes assets to the partnership,
etc.) The form has various schedules,
including a schedule K-1 which is used
to report the U.S. person’s share of
foreign partnership items of income,
expense, etc.
55
Taxation of Income from Real Estate
A nonresident alien or foreign corporation with
rental income from property in the U.S. is subject
to the flat 30-percent (or lower treaty) withholding
tax rate if the rental activity is not effectively
connected with the conduct of a trade or business
within the United States. A foreign owner of rental
real estate located in the U.S. is generally not
considered to be in a U.S. trade or business.
Taxing real estate rental income at a
flat 30-percent rate without the allowance of
allocable deductions can result in heavy tax
burdens on this type of income.
56
Taxation of Income from Real Estate
Foreign owner with real estate income
files Form 1040NR (for an individual) or
1120-F for a foreign corp, for income
that is connected with the conduct of a
trade or business.
U.S. income tax on effectively
connected income of a foreign corp. is
computed using regular corporate
income tax rates applied to net income,
after deductions for expenses.
57
Taxation of Income from Real Estate
A foreign owner of U.S. real estate may elect to
treat real property income as if it were income
effectively connected with a U.S. business. With
this election, withholding is not required, but the
owner is required to file a U.S. income tax return
and report the rental income on the return. This
enables the owner to claim deductions related to
the real property income. However no deduction is
available on a Form 1120-F, unless it is timely
filed, which can be a trap for the unwary when an
owner delays filing an election and a Form 1120-F
in the belief that no tax is due because losses are
realized.
58
Taxation of Income from Real Estate
Case. Rosas, a citizen and resident of
Mexico, organized Swallows Holding, Ltd, in
Barbados. Swallows owned 160 acres of
unimproved real estate in California (U.S.).
Swallows had a separate business activity
in Barbados, but never engaged in a trade
or business in the U.S. In a three-year
period, Swallows reported
gross income of $99,000 from rental and
options, and expenses of $179,519,
resulting in total losses of $80,518.
59
Taxation of Income from Real Estate
Case. without an election to treat income from the
real property as being effectively connected with
the conduct of a U.S. business, gross rental
revenue would have been subject to a withholding
rate of 30%. The company did not make such
election, but on its non-timely filed Forms 1120-F
had information that the IRS accepted as the
equivalent of an election. However, the IRS denied
all deductions because the corporate returns were
filed late, and assessed taxes of $14,850. After
losing the case in Tax Court, the IRS prevailed at
the appellate level.
60
Review
Suppose the owner of
India-in-Charlotte buys
a building in Charlotte
to rent to businesses?
Tax Factors?
61
Gains & Losses from Sale of Real Property
Gain or loss from a sale or other disposition
of a U.S. real property interest is taken into
account as if the seller (nonresident alien
individual or foreign corporation) were
engaged in a trade or business in the U.S.
and as if the gain or loss were effectively
connected with such trade or business.
The foreign owner must file a U.S. income
tax return, reporting the gain on the sale.
A credit is allowed for the tax that was
withheld on the disposal.
62
Gains & Losses from Sale of Real Property
A buyer (or other transferee) of a "U.S. real
property interest" from a foreign person
must withhold a tax equal to 10 percent of
the amount paid to the foreign person. U.S.
real property interest includes direct
ownership of property, and may include an
interest in a corporation that owns real
estate. Assets held by partnerships, estates
and trusts are treated as being held
proportionately by partners or beneficiaries.
63
Gains & Losses from Sale of Real Property
There are several exceptions to this
requirement, including an exemption
for persons who purchase property for
use as a residence for $300,000 or less.
The transferor can apply for and
receive a certificate from the IRS
authorizing a reduced amount of
withholding. This is appropriate where
the income tax on the gain will be less
than 10% of the selling price.
64
Income Paid to Foreign Owners
For 2005, rents and royalties were $21.5
billion, or 5.7 percent of total U.S. income
paid to foreign recipients and reported on
Form 1042S. Corp. recipients earned 92.8
percent of rents and royalties income paid
to foreign recipients. About 75% went to
residents of UK and Japan. This IRS report
does not provide separate amounts for
rental income and royalty income, but
presumably the bulk of this amount is rental
income.
65
Summary and Review
What are your
thoughts about the
impact of global
taxes on global
business?
66
Thanks for
letting me meet
with you.
Good Luck!
67
The
End
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