Essentials of taxation 2016 cengage chapter 16

Indirect Foreign Tax Credit slide 1 of 5 actual or constructive from foreign corporations – Foreign corp pays tax in foreign jurisdiction – When foreign corp remits dividends to U.S.. F

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The Big Picture (slide 1 of 3)

• VoiceCo, a domestic corporation, designs,

manufactures, and sells specialty microphones for use

in theaters

• All of its activities take place in Florida

– But, it ships products to customers all over the United

States

• When it receives some inquiries about its products

from foreign customers, VoiceCo decides to test the foreign market and places ads in foreign trade

journals.

– Soon it is taking orders from foreign customers.

The Big Picture (slide 2 of 3)

• VoiceCo is concerned about its potential foreign

income tax exposure

• Although it has no assets or employees in the foreign

jurisdictions, it now is involved in international

commerce and has many questions

– Is VoiceCo subject to income taxes in foreign countries? – Must it pay U.S income taxes on the profits from its

foreign sales?

– What if VoiceCo pays taxes to other countries?

return?

The Big Picture (slide 3 of 3)

• VoiceCo establishes a manufacturing plant in Ireland

– VoiceCo incorporates the Irish operation as

VoiceCo-Ireland, a controlled foreign corporation (CFC)

• So long as VoiceCo-Ireland does not distribute profits

to VoiceCo, will the profits escape U.S taxation?

• What are the consequences to VoiceCo of being the

owner of a so-called CFC?

• Read the chapter and formulate your response.

U.S International Tax Provisions

(slide 1 of 2)

– U.S persons earning income from outside the United

States, and

– Non-U.S persons earning income from inside the United

States

U.S International Tax Provisions

U.S Taxation of Cross-Border

Transactions

Sources of Law

(slide 1 of 3)

– Subject to both U.S law and laws of other jurisdictions in

which they operate or invest

• The Internal Revenue Code addresses the tax consequences of earning income anywhere in the world

• Must also comply with the local tax law of the other nations in which they operate

that is connected to U.S income-producing activities

Sources of Law

(slide 2 of 3)

– All tax treaties are organized in the same way

• Include provisions regarding the taxation of:

students, and teachers)

Sources of Law

(slide 3 of 3)

under the Internal Revenue Code or foreign tax statutes

Authority to Tax

(slide 1 of 2)

– The U.S allows a foreign tax credit to be claimed against

the U.S tax to reduce double-taxation (U.S and foreign) of the same income

Authority to Tax

(slide 2 of 2)

– Generally, subject to tax only on income earned within

U.S borders

Sourcing of Income

consequences to both U.S and foreign persons

– Numerous tax provisions address the income-sourcing

rules for all types of income

• These sourcing rules generally assign income to a geographic source based on the location where the economic activity producing the income took place

Allocation and Apportionment of

Deductions (slide 1 of 2)

and foreign-source income

– Deductions directly related to an activity or property are

allocated to classes of income to which they directly relate

– Then, deductions are apportioned between statutory and

residual groupings

The Big Picture – Example 8 Income Sourcing (slide 1 of 2)

• Return to the facts of The Big Picture on p 16-1

million of gross income and a $50,000 expense, all related to its

microphone manufacturing and sales

The Big Picture – Example 8 Income Sourcing (slide 2 of 2)

Allocation and Apportionment of

Deductions (slide 2 of 2)

regardless of the specific purpose for incurring the debt

– Allocation and apportionment is based on either FMV or

tax book value of assets

The Big Picture – Example 9

Apportionment Of Interest Expense

income for the current year

$23,000,000

tax book value method, interest expense is apportioned to foreign-source income as follows.

$5,000,000 (foreign assets)

$23,000,000 (total assets) X $800,000 = $173,913

Foreign Tax Credit

• Foreign tax credit (FTC) provisions are designed to

reduce the possibility of double taxation

– Allows a credit for foreign taxes paid or accrued

– FTC may be “direct” or “indirect”

• The FTC is elective for any particular tax year

– If FTC is not elected, § 164 allows a deduction for foreign

taxes paid or incurred

Direct Foreign Tax Credit

– Only person who bears the legal burden of the foreign tax

is eligible for the direct credit

country through a foreign subsidiary

Indirect Foreign Tax Credit

(slide 1 of 5)

(actual or constructive) from foreign corporations

– Foreign corp pays tax in foreign jurisdiction

– When foreign corp remits dividends to U.S corp, the

income is subject to tax in the U.S

Indirect Foreign Tax Credit

(slide 2 of 5)

• Foreign taxes are deemed paid by U.S corporate

shareholders in same proportion as dividends bear to

foreign corp’s post-1986 undistributed E & P

–Indirect FTC =

Actual or constructive dividend X Post-1986 foreign taxes

Post-1986 undistributed E & P

• Corporations choosing the FTC for deemed-paid foreign

taxes must gross up dividend income by the amount of

deemed-paid taxes

Indirect Foreign Tax Credit

(slide 3 of 5)

– Wren Inc, a domestic corp, receives a $120,000 dividend

from Finch Inc, a foreign corp Finch paid $500,000 of

foreign taxes on post-1986 E & P totaling $1,200,000 (after taxes)

Indirect Foreign Tax Credit

(slide 4 of 5)

purposes are $50,000

Deemed-paid foreign taxes

$500,000 × $ 120,000 50,000

$1,200,000

– Wren includes $170,000 in gross income for the year

for the $50,000 in deemed-paid foreign taxes

Indirect Foreign Tax Credit

(slide 5 of 5)

– Only available if domestic corp owns 10% or more of

voting stock of foreign corp

• Credit is available for 2nd and 3rd tier foreign corps if

10% ownership requirement is met at the 2nd and 3rd

levels

• Credit is also available for 4th through 6th tier foreign

corps if additional requirements are met

Foreign Tax Credit Limitations

(slide 1 of 3)

U.S taxes on U.S.-source taxable income

– FTC cannot exceed the lesser of:

• Actual foreign taxes paid or accrued, or

• U.S taxes (before FTC) on foreign-source taxable income, calculated as follows:

U.S tax × Foreign-source taxable incomebefore FTC Worldwide taxable income

Foreign Tax Credit Limitations

(slide 2 of 3)

jurisdictions from being credited

– Generating additional foreign-source income in low, or no,

tax jurisdictions could alleviate this problem

– However, a separate limitation must be calculated for

certain categories (baskets) of foreign source income

Foreign Tax Credit Limitations

(slide 3 of 3)

– Passive income, and

– All other (general)

the tax year which may be carried over

– Carryback period is 1 year

– Carryforward period is 10 years

The Big Picture – Example 13 Foreign Tax Credit Limit (slide 1 of 2)

• Return to the facts of The Big Picture on p 16-1

• Assume that VoiceCo invests in the bonds of

non-U.S corporations

• VoiceCo’s worldwide taxable income for the tax year

is $1,200,000, consisting of

– $1,000,000 of profits from U.S sales, and

– $200,000 of interest income from foreign sources

• All of the foreign income is in the passive basket.

• Foreign taxes of $90,000 were withheld by tax

authorities on these interest payments.

The Big Picture – Example 13 Foreign Tax Credit Limit (slide 2 of 2)

• VoiceCo’s U.S tax before the FTC is $420,000

• Its FTC is limited to $70,000.

• Thus, VoiceCo’s net U.S tax liability on this income

is $350,000 after allowing the $70,000 FTC

• The remaining $20,000 ($90,000 foreign tax paid -

$70,000 FTC benefit) of foreign taxes may be carried back one year or forward 10 years, for use within the passive basket.

Controlled Foreign Corporations

(slide 1 of 4)

• To minimize current tax liability, taxpayers often

attempt to defer the recognition of taxable income

– One way to do this is to shift the income-generating

activity to a foreign entity that is not within the U.S tax

jurisdiction

endeavor

• Because of the potential for abuse, Congress has

enacted various provisions to limit the availability of

deferral

Controlled Foreign Corporations

(slide 2 of 4)

corporation (CFC) is currently included in income of U.S shareholders

Controlled Foreign Corporations

(slide 3 of 4)

– Passive income such as interest, dividends, rents, and

royalties

– Sales income where neither the manufacturing activity nor

the customer base is in the CFC’s country and either the

property supplier or the customer is related to the CFC

– Service income where the CFC is providing services on

behalf of its U.S owners outside the CFC’s country

Controlled Foreign Corporations

(slide 4 of 4)

is owned by U.S shareholders on any day of tax year

– U.S shareholder is a U.S person who owns (directly or

indirectly) 10% or more of voting stock of the foreign corp

Transfer Pricing Example

(slide 1 of 3)

allowances between or among related persons when

– Necessary to prevent the evasion of taxes, or

– To reflect income more clearly

following transfer pricing example.

Transfer Pricing Example

(slide 2 of 3)

Transfer Pricing Example

(slide 3 of 3)

Inbound Issues (slide 1 of 2)

and foreign corporations is subject to U.S taxation

– A person is treated as a resident of the U.S for income tax

purposes if he or she meets either:

• The green card test, or

• The substantial presence test– If either test is met, the individual is deemed a U.S

resident for the year

– A foreign corp is one that is not domestic

Inbound Issues (slide 1 of 2)

and foreign corporations is subject to U.S taxation

– A person is treated as a resident of the U.S for income tax

purposes if he or she meets either:

• The green card test, or

• The substantial presence test– If either test is met, the individual is deemed a U.S

resident for the year

– A foreign corp is one that is not domestic

Inbound Issues (slide 1 of 2)

and foreign corporations is subject to U.S taxation

– A person is treated as a resident of the U.S for income tax

purposes if he or she meets either:

• The green card test, or

• The substantial presence test– If either test is met, the individual is deemed a U.S

resident for the year

– A foreign corp is one that is not domestic

Inbound Issues (slide 2 of 2)

alien individuals and foreign corporations when that income is effectively

connected with the conduct of a U.S trade or business.

U.S Taxation of Nonresident Aliens

(slide 1 of 3)

business

– Includes dividends, interest, rents, royalties, etc

– 30% tax must be withheld by payor of income, unless this

rate is reduced by treaty with the payee’s country of

residence

• No deductions can offset this income

U.S Taxation of Nonresident Aliens

(slide 2 of 3)

– Absent a U.S.-German treaty, $300 U.S tax is withheld,

and the German resident receives $700

• Treaties frequently reduce the withholding rates on dividends and interest

– The payor corporation remits the tax to the IRS

U.S Taxation of Nonresident Aliens

U.S Taxation of Nonresident Aliens

State Income Taxation

UDITPA and the Multistate Tax Commission

law relating to assignment of income among states for multistate corps

Commission or modeling their laws after UDITPA

UDITPA and the Multistate Tax Commission

law relating to assignment of income among states for multistate corps

Commission or modeling their laws after UDITPA

Nexus for Income Tax Purposes (slide 1 of 2)

state can impose tax on an out-of-state entity’s income

– Income is derived from within state

– Property is owned or leased in state

– Persons are employed in state

– Physical or financial capital is located in state

Nexus for Income Tax Purposes (slide 2 of 2)

personal property, with orders sent outside state for approval and shipping

to customer (Public Law 86-272)

Computing State Income Tax Liability

State Modifications (slide 1 of 2)

base

– Some of the rules adopted may differ from those used in

the Internal Revenue Code

– The state might allow a different cost recovery schedule

– The state might tax interest income from its own bonds or

from those of other states

State Modifications (slide 2 of 2)

– The state might allow a deduction for Federal income taxes

paid

– The state might disallow a deduction for payment of its

own income taxes

– The state might allow a net operating loss (NOL) deduction only for losses generated in the state

– The state’s NOL deduction might reflect different

carryover periods than Federal law allows

Allocation and Apportionment of Income

(slide 1 of 3)

states in which it conducts business

– Corp determines net income for the company as a whole

and then apportions some to a given state, according to an

approved formula

Allocation and Apportionment of Income

(slide 2 of 3)

corp’s income, net of related expenses, to a specific state

• Income or loss from sale of nonbusiness property

• Income or losses from rents or royalties from nonbusiness real or tangible personal property

Allocation and Apportionment of Income

(slide 3 of 3)

before the state’s apportionment formula is applied

– Nonapportionable income (loss) assigned to a state is then

combined with income apportionable to the state to arrive

at total income subject to tax in the state

Apportionment Procedure

• Business income is assigned to states using an apportionment formula

– Business income arises from the regular course of business

• Integral part of taxpayer’s regular business

• Nonbusiness income is apportioned or allocated to the state in which the

income-producing asset is located

Apportionment Factors

– Traditionally, states use a three-factor formula that equally

weights sales, property, and payroll

– Many states use a modified formula where sales factor

receives a larger weight

• Tends to pull larger amount of out-of state corporation's income into the state

• May provide tax relief to corps domiciled in the state

Sales Factor (slide 1 of 3)

– Numerator is corp’s sales in the state

– Denominator is corp’s total sales everywhere

– Tangible asset sales are assumed to take place at point of

delivery, not where shipping originates

Sales Factor (slide 2 of 3)

– Dock sales occur when delivery is taken at seller’s

shipping dock

• Most states apply the destination test to dock sales

the product, sale is assigned to purchaser’s state

Sales Factor (slide 3 of 3)

• If adopted by state, requires that out-of-state sales not

subject to tax in destination state be pulled back into

origination state

• Treats such sales as in-state sales of the origination state

• Also applies if purchaser is U.S government

Payroll Factor (slide 1 of 3)

– Numerator is compensation paid within a state

– Denominator is total compensation paid by the corporation

Payroll Factor (slide 2 of 3)

benefits, etc

– Some states exclude amounts paid to corporate officers

– Some states exclude deferred compensation amounts (e.g.,

401(k) plans)

Payroll Factor (slide 3 of 3)

included in payroll factor

– In states that distinguish between business and nonbusiness

income, compensation related to nonbusiness income is not included

– Compensation related to both business and nonbusiness

income is prorated between the two