The Taxation System of the U.S. Selected Topics on U.S. Taxation Munich, 29 May 2008 Lee B. Serota, Certified Public Accountant Ernst & Young AG

Seite: 2 Outline Overview of the U.S. Tax System Taxation of Individuals Definition of US Citizen/Resident Substantial Presence Test (residency termination) Measurement of Taxable Income and components of Income and Deductions U.S. federal income tax rates Non-Residents Corporate tax rates State tax rates Requirements for U.S. (and State) Payroll Social Security and Totalization Agreement 401(k) plans

Seite: 3 Overview of the U.S. tax system ► Federal taxes - Individual income tax (graduated rates up to 35%) - Corporate income tax (graduated rates up to 35%) - Estate, gift and GST (graduated rates up to 45%, reduction to 0% 2010) - Excise taxes ► State/local taxes - Individual income tax - Corporate income tax - Estate, gift and inheritance taxes - Property tax - Sales tax

Seite: 4 Some basic terms and concepts ► Inbound taxation: U.S. business/investment activities of foreign persons ► Outbound taxation: Foreign business/investment activities of U.S. persons ► United States person - resident alien - domestic corporation, partnership or trust ► Foreign person - nonresident alien - foreign corporation, partnership or trust

Seite: 5 Taxation of Individuals ► Personal Scope - Definition of residence - Begin / end of residency - Income tax treaties ► Worldwide (“unlimited”) taxation of US citizens / resident aliens - All income from whatever source derived - Tax rates (reduced for certain categories of income) - Avoidance of double taxation (foreign tax credit, foreign earned income exclusion) ► Source-based (“limited”) taxation of nonresident aliens - Gross and net-based taxation - Source rules, withholding tax - “trade or business”

Seite: 6 US Citizen / Resident ► US citizens - “All persons born or naturalized in the United States” US Constitution, XIV Amendment - Born outside the U.S. – statutory requirements (e.g., US citizen parent) - Naturalization: Immigration and Nationality Act (INA) ► Resident alien defined in U.S. Internal Revenue Code (IRC) Sec. 7701(b) - permanent resident visa (“green card”) or - substantial presence

Seite: 7 Resident alien: Definition (IRC Sec. 7701(b)) ► Permanent resident visa = “Green card” test - Starting date: first day present in the US with green card - Ending date: rescission of visa (final determination necessary) ► “Substantial presence” test day rule – weighted over a three year period: 100% of current year days 1/3 of days in preceding year 1/6 of days in second preceding - minimum of 31 days of presence in current year

Seite: 8 Example: Substantial presence test Aufenthalts- Jahr tage GewichtungErgebnis / /

Seite: 9 Example: Substantial presence test ► As the formula totals less than 183 days, the individual is considered a nonresident of the US. Aufenthalts- Jahr tage GewichtungErgebnis / /

Seite: 10 Example: Substantial presence test Aufenthalts- Jahr tage GewichtungErgebnis /3 40 2/ /6 20 1/3 183 ► As the total is 183 days, the individual is considered a resident of the US. ► Residence begins in 2007 with the first day present in the US in 2007 (Exceptions)

Seite: 11 Exceptions: Substantial Presence Presence in the US for certain individuals is disregarded (IRC Sec. 7701(b)(5)) - Diplomats - Teacher, trainee, student (subject to time limitations) - Professional athletes competing in a charitable sports event - “Get sick in the US” – US presence extended for medical reasons arising in US Closer connection exception (IRC Sec. 7701(b)(3)(B)) - Current year presence in the US is less than 183 days, - “Tax home” is in a foreign country (cf. IRC Sec. 911, 163 and treaty term “permanent home”) and - Closer connection to such foreign country than to the US (cf. Reg. § (b)-2(d) and treaty term “center of vital interests”) Limitations, e.g., in case of pending green-card application; timely-filed US tax return

Seite: 12 Taxable income – US citizen / resident Income – US taxation of worldwide income using US income tax principles Deductions (Adjustments) & Itemized Deductions - historical distinction to achieve tax policy goals - Adjustments: usually fully deductible expenses incurred in connection with a trade or business or the production of income (exceptions: e.g., certain medical expenses, IRA) - Itemized Deductions: limited deductibility of expenses that include items incurred for personal purposes (e.g., deduction of qualified residence interest or medical expenses) Standard Deduction: - minimum allowed deduction in lieu of itemizing : $ (MFJ) $5.350 (single) & (MFS) Personal exemption:$ (2007) - available for taxpayer and certain dependents (e.g., dependent children) Form 1040 used by US citizen/resident; No final assessment notice from the Internal Revenue Service (IRS)

Seite: 13 Federal Income Tax – Individuals (2007) Dividends – reduced rates through % (taxpayers in 10% or 15% bracket) - “qualified dividend”: derived from domestic and certain foreign corporations Capital gains – reduced rates through long-term capital gains (held for more than one year) - 15 % (taxpayers in 10% or 15% bracket) - 25 % tax imposed on depreciation recapture (real property) - “capital asset”- IRC Sec Deductibility of losses up to $3,000 (MFJ) or $1,500 (MFS) - Special treatment of property used in a trade or business (IRC Sec. 1231)

Seite: 14 Federal Income Tax – Individuals (2007) * ► 10 % ledigSingle(S) - $ zusammenMarried filing jointly (MFJ) - $ getrenntMarried filing separately (MFS) - $ %Single from $ to $ Married filing jointly from $ to $ Married filing separately from $ to $ %Single from $ to $ Married filing jointly from $ to $ Married filing separately from $ to $ %Single from $ to $ Married filing jointly from $ to $ Married filing separately from $ to $ %Single from $ to $ Married filing jointly from $ to $ Married filing separately from $ to $ %Single over $ Married filing jointly over $ Married filing separatelyover $ * Additional tax tables apply to an individual „head of household“ and to trusts/estates

Seite: 15 Nonresident aliens – Taxable Income US Nonresidents are taxable in the US on their US source income Two categories – IRC Sec. 871(a) and (b) 1. non-ECI: „income which is not effectively connected with the conduct of a trade or business in the United States“ IRC Sec. 871(a) → gross tax of 30% 2. ECI: „income which is effectively connected with the conduct of a trade or business in the United States“ IRC Sec. 871(b) → net-based tax (gross income less deductions) same tax rates generally applicable to US residents

Seite: 16 State taxes ► Separate state sovereignty to tax - no binding uniform system ► states are not parties to U.S. tax treaties ► Examples of tax rates: StateHighest individual tax rates California 9,3 % Illinois 3 % Texas 0 % Georgia 6 % New York 6,85 %+ City Florida 0 %

Seite: 17 U.S and State „Payroll“ ► Payroll is required to be initiated by an employer for the following employees working within the U.S.: ► Employees who are residents of the U.S. (U.S. citizens, Green Card Holders, Resident Aliens who qualify under the Substantial Presence Test). ► Non-Residents who receive compensation for which no exemption from U.S. tax exists under a tax treaty (e.g. those employees who compensation is paid or borne by U.S. companies without „charge-back“ or other allocation to a to non- U.S. entity). ► Most States within the U.S. have similar payroll rules as above. ► Note: underpayment penalties exist which can be charged to the individual for inadequate withholding on wages. Penalties also exist for the Employer if the payroll withholding is not recorded in a timely fashion and paid-in to the tax authorities.

Seite: 18 Special Topics—Social Security ► U.S. system—maximum amount assessed but no maximum for the 1.45% medicare portion (e.g. Unlimited medicare tax on worldwide compensation subject to the rules). Other elements: ► Totalization Agreement between Germany and the U.S. ► Certificate of Coverage to maintain coverage in „home country“ ► Avoidance of double coverage/taxation ► Does not cover U.S. Federal Unemployment Tax (FUTA) or State equivalent (SUTA). FUTA/SUTA generally assessed at the Employer level. ► Limited period of time for certificates of coverage ► Payroll withholding issue similar to income taxes on wages

Seite: 19 Special Topics: IRC §401(k) ► A U.S. qualified pre-tax plan at the employer level which provides for a reduction of U.S. (and State) taxable compensation for the employee. Issues: ► Allows an employee to reduce his/her taxable compensation on a yearly basis. Example: Gross compensation of $100,000 and amount contributed to the 401(k) is $15,000. Taxable compensation is $85,000. ► Restrictions as to when the employee or former employee is allowed to withdraw $ from the 401(k) plan. ► Taxation issues when the employee returns to home country and eventually withdraws the amount. ► Income tax treaty issues (Article 18: Pensions).