McGraw-Hill© 2005 The McGraw-Hill Companies, Inc. All rights reserved.

McGraw-Hill© 2005 The McGraw-Hill Companies, Inc. All rights reserved. Chapter International Business Expansion 11

McGraw-Hill© 2005 The McGraw-Hill Companies, Inc. All rights reserved. Slide 11-3 US Taxation of Foreign Operations United States taxes world wide income of all US citizens, resident aliens and domestic corporations Significant possibility of double taxation of these entities on income earned outside United States

McGraw-Hill© 2005 The McGraw-Hill Companies, Inc. All rights reserved. Slide 11-4 Tax Treaties US has tax treaties with over 50 foreign countries Common treaty provisions Restrictions on ability to tax Favorable rates Income exclusions Permanent establishment before business subject to tax

McGraw-Hill© 2005 The McGraw-Hill Companies, Inc. All rights reserved. Slide 11-5 Common Foreign Taxes Personal income tax Corporation income tax Payroll taxes Value added tax Property tax

McGraw-Hill© 2005 The McGraw-Hill Companies, Inc. All rights reserved. Slide 11-6 Foreign Taxation of Corporations-Common Features Imputation of corporation income to shareholders to relieve effects of double taxation Various methods of depreciation Rates varying from 10% to 45% Various tax incentives

McGraw-Hill© 2005 The McGraw-Hill Companies, Inc. All rights reserved. Slide 11-7 Value Added Tax Imposed on producers and distributors of products and services at each stage of production and distribution process Tax imposed on “value added” Value added is difference between sale price of product or service and non-labor costs of production Typical rates between 5% to 25%

McGraw-Hill© 2005 The McGraw-Hill Companies, Inc. All rights reserved. Slide 11-8 Foreign Tax Credit Designed to minimize or eliminate double taxation Only allowed for creditable taxes such as income tax FTC limitation= (foreign source income/world wide income) x US tax on world wide income Actual foreign tax credit is lesser of limitation or foreign taxes paid or accrued Unused credits may be carried back 2 years and forward 5 years

McGraw-Hill© 2005 The McGraw-Hill Companies, Inc. All rights reserved. Slide 11-9 Foreign Tax Credit Example J Co earns $300,000 of income in US and $150,000 in Belgium. It pays Belgian tax of $60,000. US tax liability before credits is $153,000 Foreign tax credit equal to limitation of $51,000 Carryover of $9,000

McGraw-Hill© 2005 The McGraw-Hill Companies, Inc. All rights reserved. Slide Foreign Tax Credit-Baskets Foreign tax credit is computed separately for different types of income. Limitation applies to each separately Baskets: Passive income High withholding tax income Financial services income Shipping income Certain foreign dividends

McGraw-Hill© 2005 The McGraw-Hill Companies, Inc. All rights reserved. Slide Sourcing of Income and Deductions Determines numerator of foreign tax credit limitation fraction The larger the amount of income that is foreign sourced, the larger the credit allowable

McGraw-Hill© 2005 The McGraw-Hill Companies, Inc. All rights reserved. Slide Sourcing of Income and Deductions Service income sources to where services performed Rental income sourced to location of property Royalty income sources to country where intangible asset used Interest income sourced to residence of debtor Dividend income sourced to location of dividend paying company

McGraw-Hill© 2005 The McGraw-Hill Companies, Inc. All rights reserved. Slide Sourcing of sales of property Gain or loss on real property sources to place property location Gain or loss on personal property sourced to residence of seller

McGraw-Hill© 2005 The McGraw-Hill Companies, Inc. All rights reserved. Slide Sourcing of sales of property Exceptions to general rules: Depreciation recapture sourced to where property depreciated Inventory Generally sourced to where title passes Exceptions: Manufactured inventory sourced to where manufactured Inventory manufactured in US for sale abroad sourced 50% foreign 50% US

McGraw-Hill© 2005 The McGraw-Hill Companies, Inc. All rights reserved. Slide Deduction Sourcing Generally sourced same way as income Indirect expenses apportioned between US and foreign source Interest sourced on assets IRS has broad reallocation powers under section 482

McGraw-Hill© 2005 The McGraw-Hill Companies, Inc. All rights reserved. Slide Forms of Foreign Operations Local agent Branch Partnership Controlled subsidiary

McGraw-Hill© 2005 The McGraw-Hill Companies, Inc. All rights reserved. Slide Controlled US Subsidiaries Subject to US tax on world wide income Can utilize foreign tax credit May be included in US consolidated return

McGraw-Hill© 2005 The McGraw-Hill Companies, Inc. All rights reserved. Slide Controlled Foreign Subsidiaries Not subject to US taxation until earnings distributed Parent may get deemed foreign tax credit on dividends for foreign subsidiary May not be included in US consolidated return

McGraw-Hill© 2005 The McGraw-Hill Companies, Inc. All rights reserved. Slide Subpart F Income-Effect Subpart F income earned by controlled foreign subsidiary subject to US tax when earned by subsidiary Controlled foreign subsidiary - More than 50% of stock owned by US shareholders Stock owned by U.S. shareholders owning less than 10% of stock excluded

McGraw-Hill© 2005 The McGraw-Hill Companies, Inc. All rights reserved. Slide Subpart F Income Sales to a related party if income recorded but generated in a low tax country Passive income Income from countries subject to boycott or which the US has severed relations Payments of illegal bribes

McGraw-Hill© 2005 The McGraw-Hill Companies, Inc. All rights reserved. Slide Subpart F Income Controlled corporations must keep track of both Subpart F income and income that is not Subpart F income Distributions first made from Subpart F earnings and profits and nontaxable

McGraw-Hill© 2005 The McGraw-Hill Companies, Inc. All rights reserved. Slide Transfer Pricing Section 482 used to prohibit arbitrary shifting of profits between controlled entities due to transfer pricing Goal is to get price in comparable uncontrolled transaction Methods: Resale price method Cost-plus method Comparable profits Profit split method Other method proposed by taxpayer

McGraw-Hill© 2005 The McGraw-Hill Companies, Inc. All rights reserved. Slide Advanced Pricing Agreement Agreement between taxpayer and Internal Revenue Service on transfer pricing method to be used on a specific transaction