Jurisdictional Issues in Business Taxation Chapter 12 Jurisdictional Issues in Business Taxation

Jurisdictional Issues Nexus - the right to tax Apportionment Permanent establishment in foreign country Worldwide taxation and foreign tax credits Blending high and low tax income Branch versus subsidiary Preventing abuse: Subpart F and transfer pricing

State and Local Tax Taxation requires nexus - degree of contact between business and state What does it mean to have legal domicile? What consitutes physical presence? economic nexus: regular commercial activity - law still unclear. What is the current debate surrounding internet (and catalog) sales?

Apportionment of State Income How determine State X’s share of Corporation C’s taxable income? Under UDIPTA model, apportion based on what three factor weights? About 1/2 of the state double-weight sales. Does this favor in-state or out of state businesses?

International Business Transactions - Jurisdiction Tax treaties govern the jurisdiction to tax as well as exceptions related to tax rates. Business activities are taxed only by country of residence (incorporation) unless the firm maintains a ___________ _____________ in another country. fixed location, such as an office of factory, with regular commercial operations. typically does not result from mere exporting

International Jurisdiction - continued Double taxation may result from two jurisdictions claiming right to tax the same income. Does the U.S. tax foreign income earned by U.S. corporations? If the U.S. corporation has a branch that is doing business as a permanent establishment, both the foreign country and the U.S. will tax the branch income. What relief exists for double taxation? _________ or _________. Which is better?

The Foreign Tax Credit In the U.S. (and other major trading partners), the relief comes from a foreign tax credit. Applies only to INCOME taxes. Reduce U.S. taxes by foreign income taxes paid. These rules are extremely complex, but this chapter teaches the basics.

Foreign Tax Credit Limitation The U.S. will only grant a credit up to the U.S. tax rate X foreign source taxable income. FTC limit = __________ X _______ income / worldwide income. If the firm has paid more foreign tax than the FTC limit, ___ year carryback, ____ year carryforward.

FTC Planning Firms can cross-credit between high- and low-tax rate country income. Without cross-crediting, here’s the problem: Pay tax on income in Japan branch at 50% of $100, only claim $___ FTC. Pay tax on income in Ireland branch at 10% of $100, only claim $___ FTC. Total U.S. tax on $200 x 35% = $70 - $___ FTC = $___ U.S. tax paid + $___ foreign tax paid = $___ total worldwide tax burden.

FTC Planning - Cross Credit With cross-credit, you combine all similar type foreign source income to compute limitation: FTC limit = $70 US tax X $____ foreign income / $____ worldwide income = $___. Total U.S. tax on $200 x 35% = $70 - $___ actual foreign taxes paid = $___ U.S. tax paid + $___ foreign tax paid = $___ total worldwide tax.

FTC for Alternative Minimum Tax FTC has additional limits for AMT purposes: AMT FTC limit = ______ x ____________ / worldwide AMTI. FTC cannot exceed ___% of _______.

Organizational Forms - Direct Taxation Foreign branch or partnership - the U.S. corporation is fully taxed on branch or (share of) partnership income. The U.S. corporation has a direct foreign tax credit for income taxes paid by branch or partnership. The export operation, branch or partnership may be owned by any entity in the domestic group: e.g.by a U.S. headquarters corporation or by a separate domestic subsidiary created by that purpose.

Organizational Forms - Foreign Subsidiary The foreign sub is NOT part of the consolidated U.S. return. The U.S. does not generally have the right to tax subsidiary income until what happens? Explain dividend gross-up and deemed paid credits:

Deemed-paid Credit - Example USCo pays tax at 35%. UKSub pays tax at 40%. UKSub earns $100 pretax, pays tax of $40 and has after-tax earnings of $60. If UKSub pays a dividend of all the after-tax earnings of $60, the dividend is “grossed-up” to the pre-tax amount of $____. USCo has $100 of foreign source income, but may claim a FTC of $___ subject to the FTC limitation. If this is the only foreign source income, USCo would be limited to $___ of FTC.

Deferral of U.S. Tax Because foreign subsidiary income is not taxed in the U.S. until repatriated, large tax savings result from earning income in low-tax countries and delaying repatriation. U.S. tax is deferred until repatriation. Under U.S. GAAP (APB Opinion 23), firms can avoid recording deferred tax if they state that the earnings are “permanently reinvested.”

Deferral creates incentives for tax avoidance Tax deferral creates incentives to shift income artificially into low-rate countries (“tax havens”). Examples: Place cash in Bermuda subsidiary bank account - earn interest tax-free. Sell goods at low prices to Cayman Islands; resell at high prices to foreign customers - earn tax-free profit. U.S. law prevents above abuses.

Controlled Foreign Corporations CFC is a foreign corp in which U.S. shareholders own > ___% voting power or stock value. Subpart F income of CFC is taxed as constructive dividence to all U.S. shareholders >=____% stock interest. Examples (Sec 952-954): foreign based company sales income (resale out of country with little value added) passive income Loans back to U.S. are treated as ________ (Sec 951, 956)

Transfer Pricing Where SubpartF rules do not apply, firms can engage in some income shifting between entities through transfer prices. Examples: IRS has broad powers under IRC Section ____ to reallocate income to correct unrealistic prices.