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

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Chapter 16:U.S. Taxation ofForeign-Related

Transactions

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U.S. TAX OF FOREIGN-U.S. TAX OF FOREIGN-RELATED TRANSACTIONSRELATED TRANSACTIONS

Jurisdiction to taxTaxation of U.S. citizens & residentsTaxation of nonresidentsU.S. taxation of foreign activity

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Jurisdiction to TaxJurisdiction to Tax

Taxpayer’s country of citizenshipTaxpayer’s country of residenceType of income earnedLocation where the income is

earned

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Taxation of U.S. Citizens Taxation of U.S. Citizens and Residentsand 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 creditForeign earned exclusion

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Foreign Tax Credit (FTC)(1 of 3)

FTC permits U.S. citizens and residents to avoid double taxation

Directly reduces U.S. tax liabilityFTC limited to lesser of

Foreign tax actually paid OR

foreign taxable income_ U.S. taxworldwide taxable income x liability

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Foreign Tax Credit (FTC)(2 of 3)

Source of income rules on p. C16-6– Used to determine numerator of FTC

formulaFTC deducted after nonrefundable

credits for 2004 and later years

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Foreign Tax Credit (FTC)(3 of 3)

Unused FTC carried back two years and forward five years on a FIFO basis to a year where taxpayer has an excess credit limitation

Special FTC limitation– Ten separate baskets of income

»Foreign tax credit calculated for each basket of income»See page C16-7 for partial list of baskets

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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

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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

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Foreign Earned Income Exclusion (FEI) (3 of 5)

Foreign earned income– Wages, salaries, & fees as compensation for personal

services actually renderedAmount of exclusion

– Lesser of »$80,000, OR»Foreign earned income for current year, OR»$218.58 ($80k/366 days in 2004) x no. of qualifying days in

current yr

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Foreign Earned Income Exclusion (FEI) (4 of 5)

Additional exclusion for taxable housing allowance– Limitation lesser of

»Actual housing amount included in income,OR»$11,581 (.16 x Step1 GS-14 rate) x (qualifying days/366)

– Housing costs incurred in excess of $11,581 are a for AGI deduction

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Foreign Earned Income Exclusion (FEI) (5 of 5)

Housing allowance exclusion (continued)– Housing allowance exclusion reduces

amount eligible for FEI

FTC and FEI are mutually exclusive– Claim either the FTC or the FEI on foreign

earned income, but not both

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Taxation of NonresidentTaxation of NonresidentAliens Aliens (1 of 5)(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

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Taxation of NonresidentTaxation of NonresidentAliens Aliens (2 of 5)(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

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Taxation of NonresidentTaxation of NonresidentAliens Aliens (3 of 5)(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

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Taxation of NonresidentTaxation of NonresidentAliens Aliens (4 of 5)(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

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Taxation of NonresidentTaxation of NonresidentAliens Aliens (5 of 5)(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

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Taxation of U.S. BusinessTaxation of U.S. BusinessOperating AbroadOperating Abroad

Domestic corporationsForeign corporationsDeemed paid foreign tax creditControlled foreign corporations§482 rules and tax avoidanceForeign Sales Corporations

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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)

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Foreign Corporations(1 of 2)

If domestic corp owns 10% of foreign corp, domestic corp eligible for “deemed paid credit” for dividends received from foreign corp

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Foreign Corporations(2 of 2)

10% domestic corp owner can also claim dividends received deduction

U.S. tax on foreign sub’s income deferred until dividends received

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Deemed PaidForeign Tax Credit

Deemed paid credit calculation

Div paid to domestic corp

(from post 1986 undist earningsAll post 1986 undistributed

earnings

X

Creditable taxes paid or accrued by

foreign corp (post 1986)

=Deemed

paid foreign tax

credit

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Controlled ForeignCorporations (CFC) (1 of 3)

Typical tax-avoidance scenario of a CFC

U.S.Manufacturing

Corporation(Chicago)

Foreign SalesSubsidiary

(Island Corporation)

ForeignPurchasers

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

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Controlled ForeignCorporations (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.

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Controlled ForeignCorporations (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.

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§482 Rules & Tax Avoidance(1 of 3)

Tax avoidance opportunity high for domestic parent and 100% owned subsidiary (see slide #23)– 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)

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§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

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§482 Rules & Tax Avoidance(3 of 3)

§482 Regs hold that transaction of tangible property between entities must meet arm’s-length standard– Consistent w/ transactions between

uncontrolled entities»Comparable transaction under comparable

circumstances

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Foreign SalesCorporations (FSC) (1 of 4)

FSC is a special export entity– Must meet certain mandated administrative

and economic activity requirements.

Part or all of FSC’s foreign trade income exempt from U.S. taxation– Exempt amount based on transfer pricing

method used. »May use other-than-arm’s-length pricing.

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Foreign SalesCorporations (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.

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Foreign SalesCorporations (FSC) (3 of 4)

In 2000, the World Trade Organization declared that FSCs are illegal export subsidies

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Foreign SalesCorporations (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

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Comments or questions about PowerPoint Slides?Contact Dr. Richard Newmark atUniversity of Northern Colorado’s

Kenneth W. Monfort College of Businessrichard.newmark@PhDuh.com