1. McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002 Principles of Taxation Chapter 12 Jurisdictional Issues in Business Taxation

2. Slide 12-2 McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002 Jurisdictional Issues  Nexus - the right to tax  Apportionment  Permanent establishment in foreign country  Worldwide taxation and foreign tax credits  Blending high and low tax income  Branch versus subsidiary  Preventing abuse: Subpart F and transfer pricing

3. Slide 12-3 McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002 State and Local Tax  Taxation requires nexus - degree of contact between business and state.  Having nexus in the state where incorporated is due to ___________ domicile.  What creates physical presence nexus?  Economic nexus: regular commercial activity - law still unclear.  Other issues: Catalog sales, internet sales.

4. Slide 12-4 McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002 Apportionment of State Income  How to determine State X’s share of Corporation C’s taxable income?  Under UDIPTA model, apportion based on factor weights:  About 1/2 of the state double-weight _______. Does this favor or hurt in-state businesses?

5. Slide 12-5 McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002 International Business Transactions - Jurisdiction  Tax treaties govern the jurisdiction to tax as well as exceptions related to tax rates.  Business activities are taxed by country of residence (incorporation) unless the firm maintains a______________ ______________.  Fixed location, such as an office of factory, with regular commercial operations.  Typically does not result from mere exporting.

6. Slide 12-6 McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002 International Jurisdiction - Continued  Double taxation may result from two jurisdictions claiming right to tax the same income.  U.S. taxes the _______________income of its resident taxpayers (e.g., corporations legally incorporated in the United States).  If the U.S. corporation has a branch that is doing business as a permanent establishment, who gets to tax the branch?  What relief exists for double taxation?

7. Slide 12-7 McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002 The Foreign Tax Credit  In the U.S. (and other major trading partners), the relief comes from a foreign tax credit.  Applies only to what kind of taxes?  Reduce U.S. taxes by foreign income taxes paid.  These rules are extremely complex, but this chapter teaches the basics.

8. Slide 12-8 McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002 Foreign Tax Credit Limitation  The U.S. will only grant a credit up to the U.S. tax rate X foreign source taxable income.  Equivalently, FTC limit = ________tax X ________ income / _________income. Why are these equivalent?  If the firm has paid more foreign tax than the FTC limit, ___year carryback, ____ year carryforward.

9. Slide 12-9 McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002 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 $_____ FTC.  Pay tax on income in Ireland branch at 10% of $100, only claim $_____ FTC.  Total U.S. tax on $200 x 35% = $__________ - $_____ FTC = $25 U.S. tax paid + $_____ foreign tax paid = $85 total worldwide tax burden.

10. Slide 12-10 McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002 FTC Planning – Cross-Credit  With cross-credit, you combine all similar type foreign source income to compute limitation:  FTC limit = $70 US tax X $200 foreign income / $200 worldwide income = $________.  Total U.S. tax on $200 x 35% = $70 - $_____ actual foreign taxes paid = $____ U.S. tax paid + $____ foreign tax paid = $_____ total worldwide tax.

11. Slide 12-11 McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002 FTC for Alternative Minimum Tax  FTC has an additional limit for AMT purposes.  FTC cannot exceed ______% of tentative minimum tax.

12. Slide 12-12 McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002 Organizational Forms - Direct Taxation  FSC - a ‘paper’ entity incorporated overseas that qualifies the U.S. parent for special tax exemption on export sales.  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 by that purpose.

13. Slide 12-13 McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002 Organizational Forms - Foreign Subsidiary  Can a foreign sub be part of the consolidated U.S. return?  When does the U.S. generally get to tax income earned by foreign subs?  When a dividend is repatriated out of after- tax earnings:  the dividend is foreign source earnings.  the dividend is “grossed-up.” What does this mean?  the associated tax generates a “deemed-paid” foreign tax credit.

14. Slide 12-14 McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002 Deemed-Paid Credit Example  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 of all 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 FTC of $____ subject to the FTC limitation.  If this is the only foreign source income, USCo would be limited to $____ of FTC.

15. Slide 12-15 McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002 Deferral of U.S. Tax  Because 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.”

16. Slide 12-16 McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002 Deferral Creates Incentives for Tax Avoidance  Tax deferral creates incentives to shift income artificially into low-rate countries (“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. Subpart F income (like examples above) earned by controlled foreign corporations is taxable immediately.

17. Slide 12-17 McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002 Transfer Pricing  Where SubpartF rules do not apply, firms can engage in some 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 prices.