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1 © 2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Essentials of Taxation 1 Chapter 16 Multijurisdictional Taxation

2 The Big Picture (slide 1 of 3) VoiceCo, a domestic corporation, designs, manufactures, and sells specialty microphones for use in theaters. All of its activities take place in Florida –But, it ships products to customers all over the United States. When it receives some inquiries about its products from foreign customers, VoiceCo decides to test the foreign market and places ads in foreign trade journals. –Soon it is taking orders from foreign customers.

3 The Big Picture (slide 2 of 3) VoiceCo is concerned about its potential foreign income tax exposure. Although it has no assets or employees in the foreign jurisdictions, it now is involved in international commerce and has many questions. –Is VoiceCo subject to income taxes in foreign countries? –Must it pay U.S. income taxes on the profits from its foreign sales? –What if VoiceCo pays taxes to other countries? Does it receive any benefit from these payments on its U.S. tax return?

4 The Big Picture (slide 3 of 3) VoiceCo establishes a manufacturing plant in Ireland. –VoiceCo incorporates the Irish operation as VoiceCo- Ireland, a controlled foreign corporation (CFC). So long as VoiceCo-Ireland does not distribute profits to VoiceCo, will the profits escape U.S. taxation? What are the consequences to VoiceCo of being the owner of a so-called CFC? Read the chapter and formulate your response.

5 5 U.S. International Tax Provisions (slide 1 of 2) Concerned primarily with two types of potential taxpayers: –U.S. persons earning income from outside the United States, and –Non-U.S. persons earning income from inside the United States

6 6 U.S. International Tax Provisions (slide 2 of 2) Can be organized in terms of: –Outbound taxation Refers to the U.S. taxation of foreign-source income earned by U.S. taxpayers –Inbound taxation Refers to the U.S. taxation of U.S.-source income earned by foreign taxpayers

7 U.S. Taxation of Cross-Border Transactions

8 8 Sources of Law (slide 1 of 3) U.S. individuals and companies –Subject to both U.S. law and laws of other jurisdictions in which they operate or invest The Internal Revenue Code addresses the tax consequences of earning income anywhere in the world Must also comply with the local tax law of the other nations in which they operate For non-U.S. persons, U.S. statutory law is relevant to income they earn that is connected to U.S. income-producing activities

9 9 Sources of Law (slide 2 of 3) Tax treaties exist between the U.S. and many other countries –All tax treaties are organized in the same way Include provisions regarding the taxation of: –Investment income –Business profits from a permanent establishment (PE) –Personal service income, and –Exceptions for certain persons (e.g., athletes, entertainers, students, and teachers)

10 10 Sources of Law (slide 3 of 3) Tax treaty provisions generally override the treatment otherwise called for under the Internal Revenue Code or foreign tax statutes

11 11 Authority to Tax (slide 1 of 2) The U.S. taxes U.S. taxpayers on “worldwide” income –The U.S. allows a foreign tax credit to be claimed against the U.S. tax to reduce double-taxation (U.S. and foreign) of the same income

12 12 Authority to Tax (slide 2 of 2) Foreign persons may be subject to tax in the U.S. –Generally, subject to tax only on income earned within U.S. borders

13 13 Sourcing of Income Determining the source of income is critical in calculating the U.S. tax consequences to both U.S. and foreign persons –Numerous tax provisions address the income- sourcing rules for all types of income These sourcing rules generally assign income to a geographic source based on the location where the economic activity producing the income took place

14 14 Allocation and Apportionment of Deductions (slide 1 of 2) Deductions and losses must be allocated and apportioned between U.S.- and foreign-source income –Deductions directly related to an activity or property are allocated to classes of income to which they directly relate –Then, deductions are apportioned between statutory and residual groupings

15 The Big Picture – Example 8 Income Sourcing (slide 1 of 2) Return to the facts of The Big Picture on p. 16-1. Assume that VoiceCo makes an overseas investment and generates $2 million of gross income and a $50,000 expense, all related to its microphone manufacturing and sales. The expense is allocated and apportioned on the basis of gross income.

16 The Big Picture – Example 8 Income Sourcing (slide 2 of 2)

17 17 Allocation and Apportionment of Deductions (slide 2 of 2) Interest expense is allocated and apportioned to all activities and property regardless of the specific purpose for incurring the debt –Allocation and apportionment is based on either FMV or tax book value of assets

18 The Big Picture – Example 9 Apportionment Of Interest Expense Return to the facts of The Big Picture on p. 16-1. Assume that VoiceCo generates U.S.- source and foreign-source gross income for the current year. VoiceCo’s assets (tax book value) are as follows. Assets generating U.S.-source income $18,000,000 Assets generating foreign-source income 5,000,000 $23,000,000 VoiceCo incurs interest expense of $800,000 for the current year. Using the tax book value method, interest expense is apportioned to foreign-source income as follows. $5,000,000 (foreign assets) $23,000,000 (total assets) X $800,000 = $173,913

19 19 Foreign Tax Credit Foreign tax credit (FTC) provisions are designed to reduce the possibility of double taxation –Allows a credit for foreign taxes paid or accrued Credit is a dollar-for-dollar reduction of U.S. income tax liability –FTC may be “direct” or “indirect” The FTC is elective for any particular tax year –If FTC is not elected, § 164 allows a deduction for foreign taxes paid or incurred Cannot take a credit and deduction for same foreign taxes In most situations the FTC is more valuable to the taxpayer

20 20 Direct Foreign Tax Credit Available to taxpayers who pay or incur a foreign income tax –Only person who bears the legal burden of the foreign tax is eligible for the direct credit Direct credit is not available to a U.S. corporation operating in a foreign country through a foreign subsidiary

21 21 Indirect Foreign Tax Credit (slide 1 of 5) The indirect credit is available to U.S. corporations for dividends received (actual or constructive) from foreign corporations –Foreign corp pays tax in foreign jurisdiction –When foreign corp remits dividends to U.S. corp, the income is subject to tax in the U.S.

22 22 Indirect Foreign Tax Credit (slide 2 of 5) Foreign taxes are deemed paid by U.S. corporate shareholders in same proportion as dividends bear to foreign corp’s post-1986 undistributed E & P –Indirect FTC = Actual or constructive dividend X Post-1986 foreign taxes Post-1986 undistributed E & P Corporations choosing the FTC for deemed-paid foreign taxes must gross up dividend income by the amount of deemed-paid taxes

23 23 Indirect Foreign Tax Credit (slide 3 of 5) Example – Wren Inc, a domestic corp, receives a $120,000 dividend from Finch Inc, a foreign corp. Finch paid $500,000 of foreign taxes on post-1986 E & P totaling $1,200,000 (after taxes)

24 24 Indirect Foreign Tax Credit (slide 4 of 5) Example (cont’d)- Wren’s deemed-paid foreign taxes for FTC purposes are $50,000 Cash dividend from Finch$120,000 Deemed-paid foreign taxes $500,000 × $ 120,000. 50,000 $1,200,000 Gross income to Wren$170,000 –Wren includes $170,000 in gross income for the year As a result of the dividend received, Wren can claim a credit for the $50,000 in deemed-paid foreign taxes

25 25 Indirect Foreign Tax Credit (slide 5 of 5) –Only available if domestic corp owns 10% or more of voting stock of foreign corp Credit is available for 2nd and 3rd tier foreign corps if 10% ownership requirement is met at the 2nd and 3rd levels Credit is also available for 4th through 6th tier foreign corps if additional requirements are met

26 26 Foreign Tax Credit Limitations (slide 1 of 3) Limit is designed to prevent foreign taxes from being credited against U.S. taxes on U.S.-source taxable income –FTC cannot exceed the lesser of: Actual foreign taxes paid or accrued, or U.S. taxes (before FTC) on foreign-source taxable income, calculated as follows: U.S. tax × Foreign-source taxable income before FTC Worldwide taxable income

27 27 Foreign Tax Credit Limitations (slide 2 of 3) Limitation can prevent total amount of foreign taxes paid in high-tax jurisdictions from being credited –Generating additional foreign-source income in low, or no, tax jurisdictions could alleviate this problem –However, a separate limitation must be calculated for certain categories (baskets) of foreign source income

28 28 Foreign Tax Credit Limitations (slide 3 of 3) For tax years beginning after 2006, there are only two baskets: –Passive income, and –All other (general) The FTC limitations can result in unused (noncredited) foreign taxes for the tax year which may be carried over –Carryback period is 1 year –Carryforward period is 10 years

29 The Big Picture – Example 13 Foreign Tax Credit Limit (slide 1 of 2) Return to the facts of The Big Picture on p. 16-1. Assume that VoiceCo invests in the bonds of non- U.S. corporations. VoiceCo’s worldwide taxable income for the tax year is $1,200,000, consisting of –$1,000,000 of profits from U.S. sales, and –$200,000 of interest income from foreign sources. All of the foreign income is in the passive basket. Foreign taxes of $90,000 were withheld by tax authorities on these interest payments.

30 The Big Picture – Example 13 Foreign Tax Credit Limit (slide 2 of 2) VoiceCo’s U.S. tax before the FTC is $420,000 –$1,200,000 X 35%. Its FTC is limited to $70,000. –$420,000 X ($200,000/$1,200,000). Thus, VoiceCo’s net U.S. tax liability on this income is $350,000 after allowing the $70,000 FTC. The remaining $20,000 ($90,000 foreign tax paid - $70,000 FTC benefit) of foreign taxes may be carried back one year or forward 10 years, for use within the passive basket.

31 31 Controlled Foreign Corporations (slide 1 of 4) To minimize current tax liability, taxpayers often attempt to defer the recognition of taxable income –One way to do this is to shift the income-generating activity to a foreign entity that is not within the U.S. tax jurisdiction. A foreign corporation is the most suitable entity for such an endeavor Because of the potential for abuse, Congress has enacted various provisions to limit the availability of deferral

32 32 Controlled Foreign Corporations (slide 2 of 4) Pro rata share of Subpart F income generated by a controlled foreign corporation (CFC) is currently included in income of U.S. shareholders

33 33 Controlled Foreign Corporations (slide 3 of 4) Examples of Subpart F income include: –Passive income such as interest, dividends, rents, and royalties –Sales income where neither the manufacturing activity nor the customer base is in the CFC’s country and either the property supplier or the customer is related to the CFC – Service income where the CFC is providing services on behalf of its U.S. owners outside the CFC’s country

34 34 Controlled Foreign Corporations (slide 4 of 4) A CFC is any foreign corp in which > 50% of total voting power or value is owned by U.S. shareholders on any day of tax year –U.S. shareholder is a U.S. person who owns (directly or indirectly) 10% or more of voting stock of the foreign corp

35 35 Transfer Pricing Example (slide 1 of 3) §482 gives the IRS the power to reallocate income, deductions, credits or allowances between or among related persons when –Necessary to prevent the evasion of taxes, or –To reflect income more clearly The IRS can use this power to address perceived abuses, as reflected in the following transfer pricing example.

36 36 Transfer Pricing Example (slide 2 of 3)

37 37 Transfer Pricing Example (slide 3 of 3)

38 38 Inbound Issues (slide 1 of 2) Generally, only the U.S.-source income of nonresident alien individuals and foreign corporations is subject to U.S. taxation –A person is treated as a resident of the U.S. for income tax purposes if he or she meets either: The green card test, or The substantial presence test –If either test is met, the individual is deemed a U.S. resident for the year –A foreign corp is one that is not domestic

39 39 Inbound Issues (slide 1 of 2) Generally, only the U.S.-source income of nonresident alien individuals and foreign corporations is subject to U.S. taxation –A person is treated as a resident of the U.S. for income tax purposes if he or she meets either: The green card test, or The substantial presence test –If either test is met, the individual is deemed a U.S. resident for the year –A foreign corp is one that is not domestic

40 40 Inbound Issues (slide 1 of 2) Generally, only the U.S.-source income of nonresident alien individuals and foreign corporations is subject to U.S. taxation –A person is treated as a resident of the U.S. for income tax purposes if he or she meets either: The green card test, or The substantial presence test –If either test is met, the individual is deemed a U.S. resident for the year –A foreign corp is one that is not domestic

41 41 Inbound Issues (slide 2 of 2) The United States may also tax the foreign- source income of nonresident alien individuals and foreign corporations when that income is effectively connected with the conduct of a U.S. trade or business.

42 42 U.S. Taxation of Nonresident Aliens (slide 1 of 3) Non-resident alien income not “effectively connected” with U.S. trade or business –Includes dividends, interest, rents, royalties, etc –30% tax must be withheld by payor of income, unless this rate is reduced by treaty with the payee’s country of residence No deductions can offset this income

43 43 U.S. Taxation of Nonresident Aliens (slide 2 of 3) Example: German resident earns $1,000 dividend from U.S. corporation –Absent a U.S.-German treaty, $300 U.S. tax is withheld, and the German resident receives $700 Treaties frequently reduce the withholding rates on dividends and interest –The payor corporation remits the tax to the IRS

44 44 U.S. Taxation of Nonresident Aliens (slide 3 of 3) Non-resident alien income effectively connected with U.S. trade or business –This income is taxed at the same rates that apply to U.S. citizens –Deductions for expenses related to the income may be claimed

45 45 U.S. Taxation of Nonresident Aliens (slide 3 of 3) Non-resident alien income effectively connected with U.S. trade or business –This income is taxed at the same rates that apply to U.S. citizens –Deductions for expenses related to the income may be claimed

46 46 U.S. Taxation of Nonresident Aliens (slide 3 of 3) Non-resident alien income effectively connected with U.S. trade or business –This income is taxed at the same rates that apply to U.S. citizens –Deductions for expenses related to the income may be claimed

47 47 U.S. Taxation of Nonresident Aliens (slide 3 of 3) Non-resident alien income effectively connected with U.S. trade or business –This income is taxed at the same rates that apply to U.S. citizens –Deductions for expenses related to the income may be claimed

48 48 State Income Taxation 46 states and District of Columbia impose a tax based on corp’s taxable income –Majority of states “piggyback” onto Federal income tax base Essentially, they have adopted part or all of the Federal tax provisions

49 49 UDITPA and the Multistate Tax Commission Uniform Division of Income for Tax Purposes Act (UDITPA) is a model law relating to assignment of income among states for multistate corps Many states have adopted UDITPA either by joining the Multistate Tax Commission or modeling their laws after UDITPA

50 50 UDITPA and the Multistate Tax Commission Uniform Division of Income for Tax Purposes Act (UDITPA) is a model law relating to assignment of income among states for multistate corps Many states have adopted UDITPA either by joining the Multistate Tax Commission or modeling their laws after UDITPA

51 51 Nexus for Income Tax Purposes (slide 1 of 2) Nexus is the degree of business activity which must be present before a state can impose tax on an out-of-state entity’s income Sufficient nexus typically exists if: –Income is derived from within state –Property is owned or leased in state –Persons are employed in state –Physical or financial capital is located in state

52 52 Nexus for Income Tax Purposes (slide 2 of 2) No nexus if only “connection” to state is solicitation for sale of tangible personal property, with orders sent outside state for approval and shipping to customer (Public Law 86-272) Sales tax can still apply

53 53 Computing State Income Tax Liability

54 54 State Modifications (slide 1 of 2) State modification items come about because each state creates its own tax base –Some of the rules adopted may differ from those used in the Internal Revenue Code State modification items reflect such differences, for example –The state might allow a different cost recovery schedule –The state might tax interest income from its own bonds or from those of other states

55 55 State Modifications (slide 2 of 2) State modification examples (cont’d) –The state might allow a deduction for Federal income taxes paid –The state might disallow a deduction for payment of its own income taxes –The state might allow a net operating loss (NOL) deduction only for losses generated in the state –The state’s NOL deduction might reflect different carryover periods than Federal law allows

56 56 Allocation and Apportionment of Income (slide 1 of 3) Apportionment is the means by which business income is divided among states in which it conducts business –Corp determines net income for the company as a whole and then apportions some to a given state, according to an approved formula

57 57 Allocation and Apportionment of Income (slide 2 of 3) Allocation is a method used to directly assign specific components of a corp’s income, net of related expenses, to a specific state Allocable income generally includes: Income or loss from sale of nonbusiness property Income or losses from rents or royalties from nonbusiness real or tangible personal property

58 58 Allocation and Apportionment of Income (slide 3 of 3) Typically, allocable income (loss) is removed from corporate net income before the state’s apportionment formula is applied –Nonapportionable income (loss) assigned to a state is then combined with income apportionable to the state to arrive at total income subject to tax in the state

59 59 Apportionment Procedure Business income is assigned to states using an apportionment formula –Business income arises from the regular course of business Integral part of taxpayer’s regular business Nonbusiness income is apportioned or allocated to the state in which the income- producing asset is located

60 60 Apportionment Factors Apportionment formulas vary among states –Traditionally, states use a three-factor formula that equally weights sales, property, and payroll –Many states use a modified formula where sales factor receives a larger weight Tends to pull larger amount of out-of state corporation's income into the state May provide tax relief to corps domiciled in the state

61 61 Sales Factor (slide 1 of 3) Sales factor is a fraction –Numerator is corp’s sales in the state –Denominator is corp’s total sales everywhere Most states follow UDITPA’s “ultimate destination concept” –Tangible asset sales are assumed to take place at point of delivery, not where shipping originates

62 62 Sales Factor (slide 2 of 3) –Dock sales occur when delivery is taken at seller’s shipping dock Most states apply the destination test to dock sales –If purchaser has out-of-state location to which it returns with the product, sale is assigned to purchaser’s state

63 63 Sales Factor (slide 3 of 3) –Throwback rule If adopted by state, requires that out-of-state sales not subject to tax in destination state be pulled back into origination state Treats such sales as in-state sales of the origination state Also applies if purchaser is U.S. government

64 64 Payroll Factor (slide 1 of 3) Payroll factor is a fraction –Numerator is compensation paid within a state –Denominator is total compensation paid by the corporation

65 65 Payroll Factor (slide 2 of 3) Compensation includes wages, salaries, commissions, taxable fringe benefits, etc –Some states exclude amounts paid to corporate officers –Some states exclude deferred compensation amounts (e.g., 401(k) plans)

66 66 Payroll Factor (slide 3 of 3) Only compensation related to production of apportionable income is included in payroll factor –In states that distinguish between business and nonbusiness income, compensation related to nonbusiness income is not included –Compensation related to both business and nonbusiness income is prorated between the two

67 67 Property Factor (slide 1 of 3) Property factor generally includes average value of real and tangible personal property owned or rented –Numerator is amount used in the state –Denominator is all of corp’s property owned or rented

68 68 Property Factor (slide 2 of 3) Property includes: –Land, buildings, machinery, inventory, etc –May include construction in progress, offshore property, outer space property (satellites), and partnership property Property in transit is included in numerator of destination state

69 69 Property Factor (slide 3 of 3) Property is typically valued at average historical cost plus additions and improvements –Some states allow net book value or adjusted basis to be used Leased property, when included in the property factor, is valued at eight times its annual rental payments

70 70 Allocation, Apportionment Example Total allocable income (State A) $100,000 Apportionable income (States A and B) 800,000 Total income $900,000 All sales, payroll, and property is divided equally between states A and B. Both states use identical apportionment formulas. Taxable income:State AState B 1/2 Apportionable income $400,000 $400,000 Allocable income 100,000 -0- Total state taxable income $500,000 $400,000

71 71 Apportionment Example (slide 1 of 2) Americo, Inc. operates in three states with the following apportionment systems: W's factors: average of four factors, sales double-weighted X's factors: average of three factors, equally weighted Y's factors: sales factor only State: W X YTotal Sales:$400,000 $100,000$500,000 $1,000,000 Factor 40%10% 50% Payroll: 90,000 150,000 60,000 300,000 Factor 30%50% 20% Property: 120,000 240,000 40,000 400,000 Factor 30%60% 10%

72 72 Apportionment Example (slide 2 of 2) Taxable income for year (all states)$100,000 State: W X Y Sales 40% 10%50% Sales 40% N/AN/A Payroll 30% 50%N/A Property 30% 60%N/A Total140%120%50% Average 35% 40%50% Taxable income to each state $35,000 $40,000 $50,000 Total taxed in all states:$125,000 N/A=not applicable

73 73 Apportionment Example Revisited (slide 1 of 2) Americo, Inc. moves most personnel and property to state Y. State: W X Y Total Sales: $400,000$100,000 $500,000 $1,000,000 Factor 40% 10% 50% Payroll: 30,000 30,000 240,000 300,000 Factor 10% 10% 80% Property: 40,000 40,000 320,000 400,000 Factor 10% 10%80% W's factors: average of four factors, sales double-weighted X's factors: average of three factors, equally weighted Y's factors: sales factor only

74 74 Apportionment Example Revisited (slide 2 of 2) Taxable income for year (all states)$100,000 State: W X Y Sales: 40%10%50% Sales 40% N/AN/A Payroll: 10%10%N/A Property: 10%10%N/A Total100%30%50% Average 25%10%50% Taxable income to each state $25,000 $10,000 $50,000 Total taxed in all states: $85,000 N/A = not applicable

75 75 Unitary Taxation (slide 1 of 2) Theory: operating divisions are interdependent so cannot be segregated into separate units –Each unit deemed to contribute to overall profits –Unitary theory ignores separate legal existence of companies: all combined for apportionment

76 76 Unitary Taxation (slide 2 of 2) For multistate apportionment, all divisions or entities are treated as single unitary base: –Larger apportionment base (all companies’ activities) –Smaller apportionment factors (each state’s %)

77 Refocus On The Big Picture (slide 1 of 3) Now you can address the questions about VoiceCo’s activities that were posed at the beginning of the chapter. Simply selling into a foreign jurisdiction probably will not trigger any overseas income tax consequences –But, such income is taxed currently to VoiceCo in the United States.

78 Refocus On The Big Picture (slide 2 of 3) When VoiceCo sets up a CFC in Ireland, it benefits from deferral. –As long as the income is not distributed to VoiceCo and as long as the income is not ‘‘tainted’’ Subpart F income, VoiceCo can avoid taxes on the profits of VoiceCo-Ireland. –If VoiceCo receives dividends from its foreign subsidiary, it can claim foreign tax credits, which help alleviate the double taxation that would otherwise result.

79 Refocus On The Big Picture (slide 3 of 3) What If? VoiceCo is considering building a new manufacturing facility in another state in the United States. –How will VoiceCo’s expansion decision be affected by state tax considerations? In making the decision to expand, VoiceCo should consider a variety of state tax issues including: –Whether the state imposes a corporate income tax at all and, if so, –Whether the state requires unitary reporting. Other relevant issues affecting the tax calculation in the state include: –The apportionment formula used by the state, and –Whether the state has a throwback rule.

80 © 2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 80 If you have any comments or suggestions concerning this PowerPoint Presentation for South-Western Federal Taxation, please contact: Dr. Donald R. Trippeer, CPA trippedr@oneonta.edu SUNY Oneonta


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