1 Chapter 16: U.S. Taxation of Foreign-Related Transactions

2 U.S. TAX OF FOREIGN- RELATED TRANSACTIONS  Jurisdiction to tax  Taxation of U.S. citizens & residents  Taxation of nonresidents  U.S. taxation of foreign activity

3 Jurisdiction to Tax  Taxpayer’s country of citizenship  Taxpayer’s country of residence  Type of income earned  Location where the income is earned

4 Taxation of U.S. Citizens and Residents  U.S. citizens and resident aliens taxed on worldwide income  Income earned in foreign countries or U.S. possessions receives special treatment  Foreign tax credit  Foreign earned exclusion

5 Foreign Tax Credit (FTC) (1 of 3)  FTC permits U.S. citizens and residents to avoid double taxation  Directly reduces U.S. tax liability  FTC limited to lesser of Foreign tax actually paid OR foreign taxable income _ U.S. tax worldwide taxable income x liability

6 Foreign Tax Credit (FTC) (2 of 3)  Source of income rules on p. C16-6  Used to determine numerator of FTC formula  FTC deducted after nonrefundable credits  Unused FTC carried back one year and forward ten years on a FIFO basis to a year where taxpayer has an excess credit limitation

7 Foreign Tax Credit (FTC) (3 of 3)  Special FTC limitation  Nine separate baskets of income  Foreign tax credit calculated for each basket of income  See page C16-7 for partial list of baskets  Excess FTC cannot from one basket cannot offset excess limitation amounts in another basket

8 Foreign Earned Income Exclusion (FEI) (1 of 5)  FEI available to U.S. citizens and resident aliens working abroad  Eligibility  Bona fide resident test  Resident of foreign country uninterrupted for entire tax year and maintain tax home in foreign country

9 Foreign Earned Income Exclusion (FEI) (2 of 5)  Eligibility (continued)  Physical presence test  Taxpayer must be physically present in a foreign country for 330 full days during a 12-month period, AND  Maintain a tax home in a foreign country during that period

10 Foreign Earned Income Exclusion (FEI) (3 of 5)  Foreign earned income  Wages, salaries, & fees as compensation for personal services actually rendered  Amount of exclusion  Lesser of  $80,000, OR  Foreign earned income for current year, OR  $ ($80k/365 days in 2005) x no. of qualifying days in current year

11 Foreign Earned Income Exclusion (FEI) (4 of 5)  Additional exclusion for taxable housing allowance  Limitation lesser of  Actual housing amount included in income, OR  $11,894 (.16 x Step1 GS-14 rate) x (qualifying days/365)  Housing costs incurred in excess of $11,894 are a for AGI deduction if not provided by employer

12 Foreign Earned Income Exclusion (FEI) (5 of 5)  Housing allowance exclusion (continued)  Allowance limited to lesser of employer- provided amount or the individual’s FEI  Housing allowance exclusion reduces amount eligible for FEI exclusion  FTC & FEI exclusion are mutually exclusive  Claim either the FTC or the FEI exclusion on foreign earned income, but not both

13 Taxation of Nonresident Aliens (1 of 5)  Resident aliens are taxed same as U.S. citizens  Nonresident aliens generally taxed only on U.S. source income  Taxpayer is a resident alien if they meet one of the two tests

14 Taxation of Nonresident Aliens (2 of 5)  Resident alien tests  Green-card test  Permanent resident w/ “green card” visa  Physical presence test  Present  31 days during current calendar year AND present  183 weighted average days during a three year period  Current year: 1 day counted as 1 day  Prior year: 1 day counted as 1/3 day  2nd prior year: 1 day counted as 1/6 day

15 Taxation of Nonresident Aliens (3 of 5)  Most U.S. source passive or investment income is taxed at 30%  30% applied to gross amount  U.S. payer must withhold tax  U.S. payer responsible for tax if not withheld  Tax rate often reduced by tax treaties

16 Taxation of Nonresident Aliens (4 of 5)  Income exempt from U.S. taxation  Non-USToB capital gains if individual physically present < 183 days during year  Non-USToB interest from banks or other financial institutions not taxed  Portfolio interest  Income from casual sale of personal property

17 Taxation of Nonresident Aliens (5 of 5)  Individuals must itemize deductions  Cannot claim standard deduction  Normal deductions apply for items “effectively connected” to a USToB  Gains from real property considered “effected connected” to a USToB  Tax treaties often reduce or eliminate U.S. for many types of income

18 Taxation of U.S. Business Operating Abroad  Domestic corporations  Foreign corporations  Deemed paid foreign tax credit  Controlled foreign corporations  Inversions  §482 rules and tax avoidance  Foreign Sales Corporations & Extra- territorial Income Exclusion

19 Domestic Corporations  Domestic subsidiary corporations  Can file consolidated return w/parent  Parent protected from foreign creditors of subsidiary  Foreign branches  Income and losses taxed currently  Eligible for direct FTC (described earlier)

20 Foreign Corporations  If domestic corp owns  10% of foreign corp, domestic corp eligible for “deemed paid credit” for dividends received from foreign corp   10% domestic corp owner can also claim dividends received deduction  U.S. tax on foreign sub’s income deferred until dividends received

21 Deemed Paid Foreign Tax Credit  Deemed paid credit calculation Div paid to domestic corp (from post 1986 undist earnings All post 1986 undistributed earnings X Creditable taxes paid or accrued by foreign corp (post 1986) = Deemed paid foreign tax credit

22 Controlled Foreign Corporations (CFC) (1 of 3) Typical tax-avoidance scenario of a CFC U.S. Manufacturing Corporation (Chicago) Foreign Sales Subsidiary (Island Corporation) Foreign Purchasers of U.S. Manufacturer’s Products Billing of tax haven sales subsidiary by U.S. manufacturer Billing of foreign purchasers by tax haven sales subsidiary Physical flow of goods

23 Controlled Foreign Corporations (CFC) (2 of 3)  CFC definition  > 50% of foreign corp stock owned by U.S. shareholders  U.S. shareholder defined as owning  10% of stock  Some income forms (Subpart F income) of the CFC are taxed in the year in which they are earned.  See Exhibit C16-2

24 Controlled Foreign Corporations (CFC) (3 of 3)  Tax-deferred earnings can be taxed under Subpart F when invested in U.S. property.  Previously taxed income is distributed tax-free.  Special rules apply to the sale or exchange of CFC stock.

25 §482 Rules & Tax Avoidance (1 of 3)  Tax avoidance opportunity high for domestic parent and 100% owned subsidiary (see slide #22)  U.S. parent sells goods/services at less than FMV to 100% foreign sub, OR  Foreign sub pays less than FMV for use of U.S. parent’s intangibles (e.g., patents)

26 §482 Rules & Tax Avoidance (2 of 3)  §482 authorizes IRS to distribute, apportion, or allocate gross income, deductions, credits or allowances between or among controlled entities

27 §482 Rules & Tax Avoidance (3 of 3)  §482 Regs hold that transactions between entities must meet arm’s- length standard  Consistent w/ transactions between uncontrolled entities  Comparable transaction under comparable circumstances

28 Inversions (1 of 3)  U.S. corps subject to U.S. taxation on worldwide (WW) income, while foreign corps only taxed on U.S. source income  This encourages U.S. corps with substantial foreign-source income to reorganize in a foreign country through an inversion

29 Inversions (2 of 3)  Basics of inversions 1. U.S. corp merges into a foreign entity or transfers its assets to a foreign entity 2. Owners of U.S. corp exchange U.S. corp’s stock for equity in foreign entity 3. Same owners continue to conduct both U.S. and foreign business through the new foreign entity, but only U.S. source business subject to U.S. taxation

30 Inversions (3 of 3)  §§367 and 7874 anti-inversion provisions added to prevent erosion of U.S. tax base  Under §367 a foreign corp (FC) will be deemed to be a U.S. corp if  FC acquired all assets of U.S. corp  Former U.S. corp s/hs own ≥80% of FC &  FC does not conduct much business in foreign country of incorporation

31 Foreign Sales Corporations & Extraterritorial Income Exclusion  Prior to 2005  FSC and ETI used to encourage export of U.S. goods  World Trade Organization deemed FSC and ETI to be unfair trade subsidies  FSC and ETI rules were repealed  Benefits will phase out in 2006.

32 Foreign Sales Corporations (FSC) (2 of 4)  Dividend distributions may be eligible for a 100% dividends- received deduction.  Foreign tax credit also available for taxes withheld on dividends.  FSC status restricted to foreign corps having made FSC election before 10/1/2000.

33 Foreign Sales Corporations (FSC) (3 of 4)  In 2000, the World Trade Organization declared that FSCs are illegal export subsidies

34 Foreign Sales Corporations (FSC) (4 of 4)  In 2001, U.S. replaced FSCs with extraterritorial income rules  In 2002, WTO declared extraterritorial income rules an illegal export subsidy  Congress proposed to repeal extraterritorial income rules and replace with other economic incentives

35 Comments or questions about PowerPoint Slides? Contact Dr. Richard Newmark at University of Northern Colorado’s Kenneth W. Monfort College of Business