16-1 ©2011 Pearson Education, Inc. Publishing as Prentice Hall

16-2 U.S. TAX OF FOREIGN- RELATED TRANSACTIONS (1 of 2)  Jurisdiction to tax  Taxation of U.S. citizens & resident aliens  Taxation of nonresident aliens  Taxation of U.S. businesses operating abroad ©2011 Pearson Education, Inc. Publishing as Prentice Hall

16-3 U.S. TAX OF FOREIGN- RELATED TRANSACTIONS (2 of 2)  Tax planning considerations  Compliance and procedural Considerations  Financial statement implications ©2011 Pearson Education, Inc. Publishing as Prentice Hall

16-4 Jurisdiction to Tax  U.S. authority to tax foreign-related transactions based on three factors  Taxpayer’s country of citizenship  Taxpayer’s country of residence  Location where the income is earned ©2011 Pearson Education, Inc. Publishing as Prentice Hall

16-5 Taxation of U.S. Citizens and Resident Aliens  U.S. citizens and resident aliens taxed on worldwide income  Income earned in foreign countries or U.S. possessions receives special treatment  Foreign tax credit  Foreign earned exclusion ©2011 Pearson Education, Inc. Publishing as Prentice Hall

16-6 Foreign Tax Credit (FTC) (1 of 5)  FTC permits U.S. citizens and residents to avoid double taxation  FTC directly reduces U.S. tax liability  Creditable taxes  Taxes paid or accrued in foreign country  U.S. citizens and residents eligible ©2011 Pearson Education, Inc. Publishing as Prentice Hall

16-7 Foreign Tax Credit (FTC) (2 of 5)  Translation of foreign tax payments  Cash basis taxpayers use exchange rate on date of payment  Accrual taxpayers use average exchange rate for the year ©2011 Pearson Education, Inc. Publishing as Prentice Hall

16-8 Foreign Tax Credit (FTC) (3 of 5)  FTC limited to lesser of Foreign tax actually paid OR foreign taxable income U.S. tax worldwide taxable income x liability ©2011 Pearson Education, Inc. Publishing as Prentice Hall

16-9 Foreign Tax Credit (FTC) (4 of 5)  FTC deducted after nonrefundable credits  Unused FTC carried back one year and forward ten years on a FIFO basis to a year where taxpayer has an excess credit limitation  Source of income rules on p. 6  Used to determine numerator of FTC formula ©2011 Pearson Education, Inc. Publishing as Prentice Hall

16-10 Foreign Tax Credit (FTC) (5 of 5)  Special FTC limitation  Two separate baskets of income  1)Passive income and 2)general limitation income  Foreign tax credit calculated for each basket of income  Excess FTC from one basket cannot offset excess limitation amounts in another basket ©2011 Pearson Education, Inc. Publishing as Prentice Hall

16-11 Foreign Earned Income Exclusion (FEI) (1 of 5)  FEI available to U.S. citizens and resident aliens working abroad  Eligibility  Bona fide resident test  Resident of foreign country uninterrupted for entire tax year and maintain tax home in foreign country ©2011 Pearson Education, Inc. Publishing as Prentice Hall

16-12 Foreign Earned Income Exclusion (FEI) (2 of 5)  Eligibility (continued)  Physical presence test  Taxpayer must be physically present in a foreign country for 330 full days during a 12-month period, AND  Maintain a tax home in a foreign country during that period ©2011 Pearson Education, Inc. Publishing as Prentice Hall

16-13 Foreign Earned Income Exclusion (FEI) (3 of 5)  Foreign earned income  Wages, salaries, & fees as compensation for personal services actually rendered  Amount of exclusion  Lesser of  $91,500, OR  Foreign earned income for current year, OR  $ ($91,500/365 days) x # of qualifying days in current year ©2011 Pearson Education, Inc. Publishing as Prentice Hall

16-14 Foreign Earned Income Exclusion (FEI) (4 of 5)  Additional exclusion for taxable housing allowance  Limitation lesser of  [Actual housing cost] – [16% x $91,500], OR  ($40.11/day) x (qualifying days/365), OR  (14% x $91,500) = $14,640  Housing costs incurred in excess of $14,640 are a for AGI deduction if not provided by employer ©2011 Pearson Education, Inc. Publishing as Prentice Hall

16-15 Foreign Earned Income Exclusion (FEI) (5 of 5)  Housing allowance exclusion (continued)  Allowance limited to lesser of employer- provided amount or the individual’s FEI  Housing allowance exclusion reduces amount eligible for FEI exclusion  You can claim either the FTC or FEI exclusion on foreign earned income, but not both ©2011 Pearson Education, Inc. Publishing as Prentice Hall

16-16 Taxation of Nonresident Aliens  Resident/nonresident definitions  Investment income  Trade or business income  Calculating US income tax ©2011 Pearson Education, Inc. Publishing as Prentice Hall

16-17 Resident/Nonresident Definitions (1 of 2)  Resident aliens are taxed same as U.S. citizens  Nonresident aliens generally taxed only on U.S. source income  Taxpayer is a resident alien if they meet one of the two tests ©2011 Pearson Education, Inc. Publishing as Prentice Hall

16-18 Resident/Nonresident Definitions (2 of 2)  Green-card test  Permanent resident w/ “green card” visa  Physical presence test  Present  31 days during current calendar year AND present  183 weighted average days during a three year period  Current year: 1 day counted as 1 day  Prior year: 1 day counted as 1/3 day  2nd prior year: 1 day counted as 1/6 day ©2011 Pearson Education, Inc. Publishing as Prentice Hall

16-19 Investment Income (1 of 2)  Most U.S. source passive or investment income is taxed at 30%  30% applied to gross amount  U.S. payer must withhold tax  U.S. payer responsible for tax if not withheld  Tax rate often reduced by tax treaties ©2011 Pearson Education, Inc. Publishing as Prentice Hall

16-20 Investment Income (2 of 2)  Income exempt from U.S. taxation  Non-USToB capital gains if individual physically present < 183 days during year  Non-USToB interest from banks or other financial institutions not taxed  Portfolio interest  Income from casual sale of personal property ©2011 Pearson Education, Inc. Publishing as Prentice Hall

16-21 Trade or Business Income  U.S. Trade or business (USToB)  Conducting business in US on regular basis with intent to make a profit  Income exempt from US tax if  In U.S. <90 days/yr, employed by nonresident entity, and earn <$3,000  Real estate income may be treated as USToB instead of passive income ©2011 Pearson Education, Inc. Publishing as Prentice Hall

16-22 Calculating U.S. Income Tax  Individuals must itemize deductions  Cannot claim standard deduction  Normal deductions apply for items “effectively connected” to a USToB  Gains from real property considered “effected connected” to a USToB  Tax treaties often reduce or eliminate U.S. for many types of income ©2011 Pearson Education, Inc. Publishing as Prentice Hall

16-23 Taxation of U.S. Businesses Operating Abroad  Domestic corps & Foreign branches  Foreign corporations  Deemed paid foreign tax credit  Controlled foreign corporations  Inversions  §482 rules and tax avoidance  Foreign Sales Corporations & Extra- territorial Income Exclusion ©2011 Pearson Education, Inc. Publishing as Prentice Hall

16-24 Domestic Corporations  Domestic subsidiary corporations  Can file consolidated return w/parent  Parent protected from foreign creditors of subsidiary  Foreign branches  Income and losses taxed currently  Eligible for direct FTC (described earlier) ©2011 Pearson Education, Inc. Publishing as Prentice Hall

16-25 Foreign Corporations  If domestic corp owns  10% of foreign corp, domestic corp eligible for “deemed paid credit” for dividends received from foreign corp   10% domestic corp owner cannot claim DRD on non-USToB earnings  U.S. tax on foreign sub’s income deferred until dividends received ©2011 Pearson Education, Inc. Publishing as Prentice Hall

16-26 Deemed Paid Foreign Tax Credit  Separate basket if own ≥ 10% & ≤ 50%  Called Sec. 902 or 10/50 dividends Div paid to domestic corp from undistrib earnings All undistributed earnings X Creditable taxes paid or accrued by foreign corp = Deemed paid foreign tax credit ©2011 Pearson Education, Inc. Publishing as Prentice Hall __________________

16-27 Controlled Foreign Corporations (CFC) (1 of 3) Typical tax-avoidance scenario of a CFC U.S. Manufacturing Corporation (Chicago) Foreign Sales Subsidiary (Island Corporation) Foreign Purchasers of U.S. Manufacturer’s Products Billing of tax haven sales subsidiary by U.S. manufacturer Billing of foreign purchasers by tax haven sales subsidiary Physical flow of goods ©2011 Pearson Education, Inc. Publishing as Prentice Hall

16-28 Controlled Foreign Corporations (CFC) (2 of 3)  CFC definition  > 50% of foreign corp stock owned by U.S. shareholders  U.S. shareholder defined if owns  10% of stock  Some income forms (Subpart F income) of the CFC are taxed in the year in which they are earned  See Figure 2 ©2011 Pearson Education, Inc. Publishing as Prentice Hall

16-29 Controlled Foreign Corporations (CFC) (3 of 3)  Tax-deferred earnings can be taxed under Subpart F when invested in U.S. property  Previously taxed income distributed tax-free  Special rules apply to the sale or exchange of CFC stock ©2011 Pearson Education, Inc. Publishing as Prentice Hall

16-30 §482 Rules & Tax Avoidance (1 of 3)  Tax avoidance opportunity high for domestic parent and 100% owned subsidiary (see slide 16-26)  U.S. parent sells goods/services at less than FMV to 100% foreign sub, OR  Foreign sub pays less than FMV for use of U.S. parent’s intangibles (e.g., patents) ©2011 Pearson Education, Inc. Publishing as Prentice Hall

16-31 §482 Rules & Tax Avoidance (2 of 3)  §482 authorizes IRS to distribute, apportion, or allocate gross income, deductions, credits or allowances between or among controlled entities ©2011 Pearson Education, Inc. Publishing as Prentice Hall

16-32 §482 Rules & Tax Avoidance (3 of 3)  §482 Regs hold that transactions between entities must meet arm’s- length standard  Consistent w/ transactions between uncontrolled entities  Comparable transaction under comparable circumstances ©2011 Pearson Education, Inc. Publishing as Prentice Hall

16-33 Inversions (1 of 3)  U.S. corps subject to U.S. tax on world- wide (WW) income, while foreign corps only taxed on U.S. source income  This encourages U.S. corps with substantial foreign-source income to reorganize in a foreign country through an inversion ©2011 Pearson Education, Inc. Publishing as Prentice Hall

16-34 Inversions (2 of 3)  Basics of inversions 1. U.S. corp merges into a foreign entity or transfers its assets to a foreign entity 2. Owners of U.S. corp exchange U.S. corp’s stock for equity in foreign entity 3. Same owners continue to conduct both U.S. and foreign business through the new foreign entity, but only U.S. source business subject to U.S. taxation ©2011 Pearson Education, Inc. Publishing as Prentice Hall

16-35 Inversions (3 of 3)  §§367 & 7874 added to prevent erosion of U.S. tax base  Under §367 a foreign corp (FC) will be deemed to be a U.S. corp if  FC acquired all assets of U.S. corp  Former U.S. corp s/hs own ≥80% of FC &  FC does not conduct much business in foreign country of incorporation ©2011 Pearson Education, Inc. Publishing as Prentice Hall

16-36 Tax Planning Considerations (1 of 2)  Deduction vs. credit for foreign taxes  Deduction may be beneficial when taxpayer has foreign losses or when credit is limited  Election to accrue foreign taxes  Cash method taxpayers can elect to accrue foreign taxes  Binding for all tax years and can only be revoked with IRS consent ©2011 Pearson Education, Inc. Publishing as Prentice Hall

16-37 Tax Planning Considerations (2 of 2)  Special earned income elections  Taxpayers may revoke election to exclude foreign-earned income when  Employed in foreign country where foreign tax rate > U.S. tax rate OR  Taxpayer incurs substantial loss from overseas employment ©2011 Pearson Education, Inc. Publishing as Prentice Hall

16-38 Compliance and Procedural Considerations (1 of 2)  Foreign operations of U.S. corp  Form 1120 Schedule N  Foreign tax credit  Form 1118 (corp), Form 1116 (individual)  Foreign earned income exclusion  Form 2555 or 2555-EZ ©2011 Pearson Education, Inc. Publishing as Prentice Hall

16-39 Compliance and Procedural Considerations (2 of 2)  Nonresident aliens  Form 1040-NR  Foreign corporations  Form 1120-F ©2011 Pearson Education, Inc. Publishing as Prentice Hall

16-40 Financial Statement Implications (1 of 2)  Foreign tax credit  Excess FTC creates deferred tax asset  Deferred foreign earnings  Normally would create a deferred tax asset ©2011 Pearson Education, Inc. Publishing as Prentice Hall

16-41 Financial Statement Implications (2 of 2)  Deferred foreign earnings (continued)  ASC 740 (SFAS 109) exception for indefinite reinvestment  No deferred tax asset unless temporary difference expected to reverse in forseable future ©2011 Pearson Education, Inc. Publishing as Prentice Hall

Comments or questions about PowerPoint Slides? Contact Dr. Richard Newmark at University of Northern Colorado’s Kenneth W. Monfort College of Business ©2011 Pearson Education, Inc. Publishing as Prentice Hall