Chapter 13 Jurisdictional Issues in Business Taxation McGraw-Hill/Irwin Copyright © 2014 by The McGraw-Hill Companies, Inc. All rights reserved.

13-2Objectives  Nexus - the right to tax  Apportionment  Permanent establishment in foreign country  Foreign tax credits  Blending high and low tax income  Branch versus subsidiary  Deemed paid foreign tax credit  Preventing abuse: Subpart F and transfer pricing

13-3 State and Local Tax  Increasingly, firms and their tax advisors are formulating strategies to reduce state and local taxes, such as real and personal property taxes, unemployment taxes, and sales & use taxes  For a state tax to be constitutional, it must not discriminate against interstate commerce  E.g., an income tax of 3% for resident corporations and 5% for non resident corporations would be unconstitutional

13-4 State and Local Tax  State taxes can only be levied on businesses having nexus - degree of contact between business and the state Nexus can be established via  Legal domicile: nexus in the state where incorporated  Physical presence: employees or real or personal property; however, sales reps alone do not create nexus  Regular commercial activity is argued by some states to create an economic nexus; the law is still unclear  Other issues: catalog sales, internet sales

13-5 Apportionment of State Income  States may tax only the income attributable to a firm’s in-state business activity; how is State X’s share of Corporation C’s taxable income determined?  Under UDITPA (Uniform Division of Income for Tax Purposes Act) model, apportion based on factor weights  Sales  Payroll  Property (cost)  Over 1/2 of the states double-weight sales; this favors in-state businesses  Other states only consider sales factor

13-6 International Business Transactions - Jurisdiction  Tax treaties govern the jurisdiction to tax as well as exceptions related to tax rates  Business activities are taxed only by the country of residence (incorporation) unless the firm maintains a permanent establishment in another country  E.g., a fixed location, such as an office or factory, with regular commercial operations (but not merely exporting)  If there is no tax treaty, uncertainty may exist as to what level of activity triggers jurisdiction

13-7 International Jurisdiction - continued  Double taxation may result from two jurisdictions claiming the right to tax the same income  The U.S. taxes the worldwide income of its citizens, permanent residents, and domestic corporations  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

13-8 International Jurisdiction - continued  What relief exists for double taxation?  Deduction for foreign taxes, or  Foreign tax credit

13-9 The Foreign Tax Credit  In the U.S., relief usually comes from a foreign tax credit  Applies only to income taxes – not foreign excise, value-added, sales, property or transfer taxes  Reduces U.S. taxes by foreign income taxes paid  These rules are extremely complex; this chapter teaches the basics

13-10 Foreign Tax Credit Limitation  The U.S. will only grant a credit up to the amount of [U.S. tax rate x foreign source taxable income]  FTC limit = U.S. tax x (foreign income / worldwide income)  If the firm has paid more foreign tax than the FTC limit, the firm is allowed 1 year carryback, 10 year carryforward  Carryovers are limited to the annual FTC limit discussed above

13-11 Example: Foreign Tax Credit Limitation  ABC Inc. had $1,000,000 taxable income; $250,000 of which was generated by business activities in Utopia. ABC paid $112,500 foreign tax to Utopia. It’s US income tax is  US Source income$ 750,000  Foreign Source income 250,000  Taxable income$1,000,000  Tax Liability (34%) 340,000  Foreign Tax Credit (limited) (85,000)  US Tax Due $255,000

13-12 Example continued  ABC’s foreign tax credit is limited to the precredit US tax liability of $340,000 multiplied by 25% ($250,000 foreign source income divided by $1,000,000 taxable income) or $85,000

13-13 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

13-14 FTC Planning - Cross Credit  With cross-credit, you combine all similar type foreign source income to compute the 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

13-15 Organizational Forms - Direct Taxation  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 for that purpose

13-16 Organizational Forms - Foreign Subsidiary  US corporations often create subsidiaries under the laws of a foreign jurisdiction to operate foreign businesses  The foreign sub is not part of the consolidated U.S. return  What is the impact of this type of arrangement on losses?  The losses of the foreign subsidiary cannot offset income of the parent and vice versa

13-17 Foreign Subsidiary  The U.S. does not generally have the right to tax subsidiary income until it is paid back to the U.S. parent company (i.e., “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 if the US corporation owns 10% or more of the voting stock of the foreign subsidiary

13-18 Example: Deemed-paid Credit  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 equal to 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 $40 FTC subject to FTC limitation  If this is the only foreign source income, USCo would be limited to $35 of FTC

13-19 Deferral of U.S. Tax  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”

13-20 Deferral Creates Incentives for Tax Avoidance  Tax deferral creates incentives to shift income artificially into low-rate countries (i.e.,“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

13-21 Controlled Foreign Corporations (CFCs)  CFC is a foreign corporation in which U.S. shareholders own > 50% voting power or stock value  If a CFC earns certain types of income, the law treats it as if it were immediately distributed to the shareholders  Subpart F income is “artificial” because it has no commercial or economic connection to the CFC’s home country

13-22 Controlled Foreign Corporations (CFCs)  Subpart F income of a CFC is taxed as constructive dividend to all U.S. shareholders >=10% stock interest Examples  Foreign-based company sales income; resale out of country with little value added  passive income  Loans from CFC back to U.S. parent are treated as constructive dividends and taxed

13-23 Transfer Pricing  Where Subpart F rules do not apply, firms can engage in some income 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 transfer prices

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