McGraw-Hill/Irwin Copyright (c) 2002 by the McGraw-Hill Companies Inc Principles of Taxation: Advanced Strategies Chapter 10 Chapter 10 International Business Expansion International Business Expansion Slide 10-1

McGraw-Hill/Irwin Copyright (c) 2002 by the McGraw-Hill Companies Inc US Taxation of Foreign Operations United States taxes world wide income of all US citizens, resident aliens and domestic corporations 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 Significant possibility of double taxation of these entities on income earned outside United States Slide 10-2

McGraw-Hill/Irwin Copyright (c) 2002 by the McGraw-Hill Companies Inc Tax Treaties Slide 10-3 US has tax treaties with over 50 foreign countries US has tax treaties with over 50 foreign countries Common treaty provisions Common treaty provisions  Restrictions on ability to tax  Favorable rates  Income Exclusions

McGraw-Hill/Irwin Copyright (c) 2002 by the McGraw-Hill Companies Inc Common Foreign Taxes Personal income tax Personal income tax Corporation income tax Corporation income tax Payroll taxes Payroll taxes Value added tax Value added tax Property tax Property tax Slide 10-4

McGraw-Hill/Irwin Copyright (c) 2002 by the McGraw-Hill Companies Inc Foreign Taxation of Corporations – Common Features Imputation of corporation income to shareholders to relieve effects of double taxation Imputation of corporation income to shareholders to relieve effects of double taxation Various methods of depreciation Various methods of depreciation Rates varying from 15% to 45% Rates varying from 15% to 45% Various tax incentives Various tax incentives Slide 10-5

McGraw-Hill/Irwin Copyright (c) 2002 by the McGraw-Hill Companies Inc Value Added Tax Imposed on producers and distributors of products and services at each stage of production and distribution process Imposed on producers and distributors of products and services at each stage of production and distribution process Tax imposed on “value added” 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% Typical rates between 5% to 25% Slide 10-6

McGraw-Hill/Irwin Copyright (c) 2002 by the McGraw-Hill Companies Inc Foreign Tax Credit Designed to minimize or eliminate double taxation Designed to minimize or eliminate double taxation Only allowed for creditable taxes such as income tax Only allowed for creditable taxes such as income tax FTC limitation = (foreign source income/world wide income) x US tax on world wide income 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 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 Unused credits may be carried back 2 years and forward 5 years Slide 10-7

McGraw-Hill/Irwin Copyright (c) 2002 by the McGraw-Hill Companies Inc Foreign Tax Credit Example J Co earns $ 300,000 of income in US and 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 Slide 10-8 Foreign tax credit equal to limitation of $ 51,000 Carryover of $ 10,000

McGraw-Hill/Irwin Copyright (c) 2002 by the McGraw-Hill Companies Inc Foreign Tax Credit – Baskets Foreign tax credit is computed separately for different types of income. Limitation applies to each separately Foreign tax credit is computed separately for different types of income. Limitation applies to each separately Baskets: Baskets:  Passive income  High withholding tax income  Financial services income  Shipping income  Certain foreign dividends Slide 10-9

McGraw-Hill/Irwin Copyright (c) 2002 by the McGraw-Hill Companies Inc 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 Slide 10-10

McGraw-Hill/Irwin Copyright (c) 2002 by the McGraw-Hill Companies Inc Sourcing of Income and Deductions Service income sources to where services performed Service income sources to where services performed Rental income sourced to location of property Rental income sourced to location of property Interest income sourced to residence of debtor Interest income sourced to residence of debtor Dividend income sourced to location of dividend paying company Dividend income sourced to location of dividend paying company Slide 10-11

McGraw-Hill/Irwin Copyright (c) 2002 by the McGraw-Hill Companies Inc Sourcing of Sales of Property General rule: income sourced to residence of seller General rule: income sourced to residence of seller Exceptions: Exceptions:  Depreciation recapture sourced to where property depreciated  Inventory  Generally sourced to where title passes Exceptions:Exceptions: –Manufactured inventory sourced to where manufactured –Inventory manufactured in US for sale abroad sourced 50% foreign 50% US Slide 10-12

McGraw-Hill/Irwin Copyright (c) 2002 by the McGraw-Hill Companies Inc Deduction Sourcing Slide Generally sourced same way as income Generally sourced same way as income Indirect expenses apportioned between US and foreign source Indirect expenses apportioned between US and foreign source Interest sourced on assets Interest sourced on assets IRS has broad reallocation powers under section 482 IRS has broad reallocation powers under section 482

McGraw-Hill/Irwin Copyright (c) 2002 by the McGraw-Hill Companies Inc Forms of Foreign Operations Local agent Local agent Branch Branch Partnership Partnership Controlled subsidiary Controlled subsidiary Slide 10-14

McGraw-Hill/Irwin Copyright (c) 2002 by the McGraw-Hill Companies Inc Controlled US Subsidiaries Subject to US tax on world wide income Subject to US tax on world wide income Can utilize foreign tax credit Can utilize foreign tax credit May be included in US consolidated return May be included in US consolidated return Slide 10-15

McGraw-Hill/Irwin Copyright (c) 2002 by the McGraw-Hill Companies Inc Controlled Foreign Subsidiaries Not subject to US taxation until earnings distributed 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 May not be included in US consolidated return Slide 10-16

McGraw-Hill/Irwin Copyright (c) 2002 by the McGraw-Hill Companies Inc Subpart F Income – Effect Subpart F income earned by controlled foreign subsidiary subject to US tax when earned by subsidiary 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 Controlled foreign subsidiary – More than 50% of stock owned by US shareholders Slide 10-17

McGraw-Hill/Irwin Copyright (c) 2002 by the McGraw-Hill Companies Inc Subpart F Income Sales to a related party Sales to a related party Passive income Passive income Income from countries subject to boycott or which the US has severed relations Income from countries subject to boycott or which the US has severed relations Payments of illegal bribes Payments of illegal bribes Slide 10-18

McGraw-Hill/Irwin Copyright (c) 2002 by the McGraw-Hill Companies Inc Subpart F Income Slide Controlled corporations must keep track of both Subpart F income and income that is not 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 Distributions first made from Subpart F earnings and profits and nontaxable

McGraw-Hill/Irwin Copyright (c) 2002 by the McGraw-Hill Companies Inc Transfer Pricing Section 482 used to prohibit arbitrary shifting of profits between controlled entities due to 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 Goal is to get price in comparable uncontrolled transaction Methods: Methods:  Resale price method  Cost-plus method  Comparable profits  Profit split method Slide 10-20