Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 Principles of Taxation Chapter 12 Jurisdictional Issues in Business Taxation

Slide 12-2 Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 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

Slide 12-3 Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 State and Local Tax  Taxation requires nexus - degree of contact between business and state  legal domicile (there is nexus in the state where incorporated).  physical presence: employees or real or personal property. (sales reps do not create nexus).  economic nexus: regular commercial activity - law still unclear.  Other issues: catalog sales, internet sales.

Slide 12-4 Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 Apportionment of state income  How determine State X’s share of Corporation C’s taxable income?  Under UDIPTA model, apportion based on 3- factor weights:  sales  payroll  property  About 1/2 of the state double-weight sales. This favors in-state businesses.

Slide 12-5 Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 International Business Transactions - jurisdiction  Tax treaties govern the jurisdiction to tax as well as exceptions related to tax rates.  Business activities are taxed by country of residence (incorporation) unless the firm maintains a permanent establishment.  fixed location, such as an office of factory, with regular commercial operations.  typically does not result from mere exporting

Slide 12-6 Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 International jurisdiction - continued  Double taxation may result from two jurisdictions claiming right to tax the same income.  U.S. taxes the worldwide income of its resident taxpayers (e.g., corporations legally incorporated in the United States).  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?

Slide 12-7 Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 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.

Slide 12-8 Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 Foreign tax credit limitation  The U.S. will only grant a credit up to the U.S. tax rate X foreign source taxable income.  Equivalently, FTC limit = U.S. tax X foreign income / worldwide income.  If the firm has paid more foreign tax than the FTC limit, 2 year carryback, 5 year carryforward.

Slide 12-9 Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 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 $35 FTC.  Pay tax on income in Ireland branch at 10% of $100, only claim $10 FTC.  Total U.S. tax on $200 x 35% = $70 - $45 FTC = $25 U.S. tax paid + $60 foreign tax paid = $85 total worldwide tax burden.

Slide Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 FTC Planning - cross credit  With cross-credit, you combine all similar type foreign source income to compute limitation:  FTC limit = $70 US tax X $200 foreign income / $200 worldwide income = $70.  Total U.S. tax on $200 x 35% = $70 - $60 actual foreign taxes paid = $10 U.S. tax paid + $60 foreign tax paid = $70 total worldwide tax.

Slide Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 FTC for Alternative Minimum Tax  FTC has an additional limit for AMT purposes:  FTC cannot exceed 90% of tentative minimum tax.

Slide Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 Organizational Forms - direct taxation  FSC - an ‘paper’ entity incorporated overseas that qualifies the U.S. parent for special tax exemption on export sales.  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.

Slide Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 Organization 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 it is paid back to the U.S. parent company (“repatriated”).  When a dividend is repatriated out of after- tax earnings:  the dividend is foreign source earnings  the dividend is “grossed-up” (add back tax) to a pre-tax amount  the associated tax generates a “deemed-paid” foreign tax credit.

Slide Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 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 $100.  USCo has $100 of foreign source income, but may claim a FTC of $40 subject to the FTC limitation.  If this is the only foreign source income, USCo would be limited to $35 of FTC.

Slide Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 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.”

Slide Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 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. Subpart F income (like examples above) earned by controlled foreign corporations is taxable immediately.

Slide Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 Transfer pricing  Where SubpartF rules do not apply, firms can engage in some shifting between entities through transfer prices. Examples:  Pay royalties from high-tax entities to low-tax entities.  Charge higher prices to high-tax entities for goods and services.  Pay management fees from high-tax entities to low- tax entities.  IRS has broad powers under IRC Section 482 to reallocate income to correct unrealistic prices.