Module 18 Where to Do Business

Menu 1. International tax treaties 2. Sources of income and allocation of deductions 3. Tax credits 4. Taxation of foreign corporations 5. Issues in multistate taxation

International Tax Treaties Key Learning Objectives n Introduction to multinational taxation n International tax treaties n Countries with which the U.S. has income tax treaties n Model tax treaty

International Tax Treaties n n The United States is a party to tax treaties with over 40 countries n n The basic goals of treaties are to u Minimize the double taxation of income from international transactions u Increase cooperation among tax authorities

International Tax Treaties n n Reduce the tax due to the country that is the source of income by u Overriding the statute law of the source country u Providing tax reductions or exemptions for certain types of transactions

Supreme Law of the Land n n The Constitution n n The laws of the U.S. made under the Constitution n n All treaties made or to be made under the authority of the U.S.

Treaty or U.S. Tax Law? n n Neither a treaty nor a law has preferential status by reason of its being a treaty or a law n n When a revenue statute and a treaty provision conflict, generally the one adopted later controls

Sources of Income and Allocation of Deductions Key Learning Objectives n n Sources of income n n Allocation of expenses and deductions n n Apportioning expenses to U.S. and foreign source income n n Effect of tax treaties on source rules

U.S. Domestic Corporations and Individuals Who Are U.S. Citizens or Residents n Subject to U.S. taxation on their worldwide incomes

Foreign Corporations and Nonresident Alien Individuals n Subject to U.S. taxation on income from u Sources within the United States u Foreign sources if effectively connected with a U.S. trade or business

Allocation and Apportionment of Expenses n First allocate all deductions to specific classes of income u Reg § (a)(3) lists 15 classes of income n Then apportion the deductions to the U.S. and foreign source gross income within the class u By comparison of the units sold, gross income, or other method that reflects the relationship between the expense and the income

Tax Credits Key Learning Objectives n n Tax credits n n Foreign tax credit or deduction n n Taxes that qualify for the foreign tax credit n n Separate limitations n n Claiming the credit n n Tax credit for income from U.S. possessions

Foreign Tax Credits FTC n May elect either to deduct foreign taxes or n Use them as a credit against U.S. Tax n Can make or change the election any time before the expiration of the period for claiming a refund for the taxable year

Foreign Tax Credits FTC n FTC is equal to the portion of U.S. tax liability that results from inclusion of foreign source income n Cannot exceed the amount of foreign taxes paid or accrued during the year.

Taxes That Qualify for FTC n Imposed by foreign countries or U.S. possessions on income, war, or excess profits n Imposed in lieu of income taxes upon gross income, gross sales, or units of production u If the predominant character is that of an income tax n “Deemed paid” income taxes

Taxation of Foreign Corporations Key Learning Objectives n n Taxation of foreign corporations n n Controlled Foreign Corporations (CFC) n n Foreign Sales Corporations (FSC)

Foreign Corporation n Any association, joint stock company, or insurance company that is u Not organized in the U.S. u Under laws of a state or District of Columbia n Generally subject to U.S. Taxation only on their U.S. Source income that is u Effectively connected with the conduct of a U.S. Trade or business

Controlled Foreign Corporation n n > 50 % of the total voting power or total value of the stock is owned BY n n U.S. shareholders on any day during the taxable year u Stock can be owned directly or u Indirectly through attribution n n Must be CFC for > 30 days in tax year before shareholder has problems

U.S. Shareholder of Foreign Corporation n n May be taxed on foreign income before it is even distributed IF n n Owns > 10 % the stock on the last day of taxable year OF n n Corporation = CFC > 30 days in year AND n n Corporation has u Subpart F income OR u Increased E&P invested in U.S. property

Foreign Sales Corporation FSC n n Exempt from U.S. taxation on a portion of its foreign trade income n n A U.S. corporation will: u Organize a FSC u Export its goods and services through the FSC u Reduce its income by paying the FSC a commission

Foreign Sales Corporation FSC n n FSC distributes a dividend to the U.S. corporation n n The U.S. corporation includes dividend in gross income BUT n n Some or all of the dividend will qualify for the dividends received deduction

Issues in Multistate Taxation Key Learning Objectives (1) n n Multistate taxation--an overview n n Due process and commerce clauses n n What constitutes nexus? n n Unitary principle

Multistate Taxation n n All states impose state income taxes or value-added taxes on corporations u Except Nevada, South Dakota, Washington, and Wyoming n n Many states also hold businesses responsible for collecting and remitting the sales and use taxes imposed on the buyers of their products

Multistate Taxation Right to Tax n n The state in which a business is organized can tax all income earned

Multistate Taxation Right to Tax n n In order to tax income from interstate business n n A state's system of taxation must satisfy Two separate and independent clauses of the U.S. Constitution The Due Process Clause The Commerce Clause

Due Process Clause n n Requires a minimum connection between u A state and u The transaction, property, or party that it seeks to tax. n n This connection is referred to as nexus.

Establish Nexus by Maintaining in the State n n An office or other place of business u Distribution facility, warehouse, or sales office, n n Inventory or other property n n A sample or display room in excess of two weeks at any one location during the tax year

Establish Nexus by Administrative Functions n n Conducting training classes, seminars, or lectures u Other than for personnel involved in solicitation n n Investigating credit worthiness n n Collecting current or delinquent accounts n n Repossessing property

Establish Nexus by Providing n n Installation n n Repairs or maintenance n n Technical assistance or services u When one of the purposes is not the facilitation of the solicitation of orders

Commerce Clause Four Requirements n n There must be substantial nexus between the corporation and the taxing state n n Tax must be fairly related to the benefits provided to the taxpayer by the state n n The tax may not discriminate against interstate commerce n n The tax must be fairly apportioned

Unitary Theory n In 1983 the Supreme Court held that states can include the income of foreign subsidiaries in determining the tax liability n Most states that require combined apportionment do not require income to be reported on a worldwide basis

Issues in Multistate Taxation Key Learning Objectives (2) n n Allocation of income n n Apportionment of income n n Sales and use taxes

Non-Business Income n All income other than business income n May include passive income u Rents, royalties, interest, dividends, and certain capital gains n Income is usually reduced by the expenses incurred to earn it

Allocation of Non-Business Income n Usually allocated to u The state where the income-producing property is located OR u To the state of commercial domicile F The principal place from which the corporation's business is managed or directed

Business Income n Income from transactions and activities in the regular course of the taxpayer's trade or business n Includes income from tangible and intangible property IF Acquisition, management, and disposition of the property are integral parts of the regular business

Apportionment of Business Income n Using a formula designed to measure the proportion of business activity conducted in each state n The most common apportionment method is the standard three-factor formula u Uses three equally weighted factors F Property F Payroll F Sales

Apportionment The Three Factor Formula (1) n First, determine these percentages Property located in state Total property Payroll located in state Total payroll Sales located in state Total sales

Apportionment The Three Factor Formula (2) n Average the three percentages n Use average to apportion income to state n Note that income or loss that is allocable is u Deducted from the corporation's net income u Before the apportionment percentage is applied

Sales Taxes n Imposed on the consumer of goods n Some states also levy sales taxes on services u Such as repairs and utilities n Imposed only on sales where the seller and the buyer are in the same state

Use Taxes n Charged when levying a sales tax is not permissible u Vendor is out of state n Use taxes are assessed on the privilege of owning or consuming tangible personal property in a state

Collecting Sales and Use Taxes n Responsibility is imposed on the vendor n If a vendor fails to collect, the uncollected tax becomes the vendor's liability

Nexus and Sales and Use Taxes n Vendors that are engaged in interstate sales are not required to collect sales taxes UNLESS n The vendor has sufficient nexus with the state in which the customer is located u Generally excludes catalogue sales if shipped from out of state