Chapter 13Chapter 13

Jurisdictional Issues in Business Taxation

McGraw-Hill/Irwin Copyright © 2014 by The McGraw-Hill Companies, Inc. All rights reserved.

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ObjectivesObjectives

Nexus - the right to tax Apportionment Permanent establishment in foreign country Foreign tax credits Blending high and low tax income Branch versus subsidiary Deemed paid foreign tax credit Preventing abuse: Subpart F and transfer pricing

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State and Local TaxState and Local Tax

Increasingly, firms and their tax advisors are formulating strategies to reduce state and local taxes, such as real and personal property taxes, unemployment taxes, and sales & use taxes

For a state tax to be constitutional, it must not discriminate against interstate commerce E.g., an income tax of 3% for resident

corporations and 5% for non resident corporations would be unconstitutional

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State and Local TaxState and Local Tax

State taxes can only be levied on businesses having nexus - degree of contact between business and the state Nexus can be established via Legal domicile: nexus in the state where incorporated Physical presence: employees or real or personal

property; however, sales reps alone do not create nexus Regular commercial activity is argued by some states to

create an economic nexus; the law is still unclear

Other issues: catalog sales, internet sales

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Apportionment of State IncomeApportionment of State Income

States may tax only the income attributable to a firm’s in-state business activity; how is State X’s share of Corporation C’s taxable income determined?

Under UDITPA (Uniform Division of Income for Tax Purposes Act) model, apportion based on factor weights Sales Payroll Property (cost)

Over 1/2 of the states double-weight sales; this favors in-state businesses

Other states only consider sales factor

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International Business Transactions - JurisdictionInternational Business Transactions - Jurisdiction

Tax treaties govern the jurisdiction to tax as well as exceptions related to tax rates

Business activities are taxed only by the country of residence (incorporation) unless the firm maintains a permanent establishment in another country E.g., a fixed location, such as an office or

factory, with regular commercial operations (but not merely exporting)

If there is no tax treaty, uncertainty may exist as to what level of activity triggers jurisdiction

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International Jurisdiction - continuedInternational Jurisdiction - continued

Double taxation may result from two jurisdictions claiming the right to tax the same income

The U.S. taxes the worldwide income of its citizens, permanent residents, and domestic corporations

If the U.S. corporation has a branch that is doing business as a permanent establishment, both the foreign country and the U.S. will tax the branch income

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International Jurisdiction - continuedInternational Jurisdiction - continued

What relief exists for double taxation? Deduction for foreign taxes, or Foreign tax credit

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The Foreign Tax CreditThe Foreign Tax Credit

In the U.S., relief usually comes from a foreign tax credit

Applies only to income taxes – not foreign excise, value-added, sales, property or transfer taxes

Reduces U.S. taxes by foreign income taxes paid

These rules are extremely complex; this chapter teaches the basics

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Foreign Tax Credit LimitationForeign Tax Credit Limitation

The U.S. will only grant a credit up to the amount of [U.S. tax rate x foreign source taxable income]

FTC limit = U.S. tax x (foreign income / worldwide income)

If the firm has paid more foreign tax than the FTC limit, the firm is allowed 1 year carryback, 10 year carryforward Carryovers are limited to the annual

FTC limit discussed above

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Example: Foreign Tax Credit LimitationExample: Foreign Tax Credit Limitation

ABC Inc. had $1,000,000 taxable income; $250,000 of which was generated by business activities in Utopia. ABC paid $112,500 foreign tax to Utopia. It’s US income tax is US Source income $ 750,000 Foreign Source income 250,000 Taxable income $1,000,000 Tax Liability (34%) 340,000 Foreign Tax Credit (limited) (85,000) US Tax Due $255,000

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Example continuedExample continued

ABC’s foreign tax credit is limited to the precredit US tax liability of $340,000 multiplied by 25% ($250,000 foreign source income divided by $1,000,000 taxable income) or $85,000

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FTC PlanningFTC 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 $35 FTC Pay tax on income in Ireland branch at

10% of $100, only claim $10 FTC Total U.S. tax on $200 x 35% = $70 - $45 FTC =

$25 U.S. tax paid + $60 foreign tax paid = $85 total worldwide tax burden

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FTC Planning - Cross CreditFTC Planning - Cross Credit

With cross-credit, you combine all similar type foreign source income to compute the limitation FTC limit = $70 US tax x ($200 foreign income / $200

worldwide income) = $70 Total U.S. tax on $200 x 35% = $70 - $60 actual foreign

taxes paid = $10 U.S. tax paid + $60 foreign tax paid = $70 total worldwide tax

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Organizational Forms - Direct TaxationOrganizational Forms - Direct Taxation

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 for that purpose

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Organizational Forms - Foreign SubsidiaryOrganizational Forms - Foreign Subsidiary

US corporations often create subsidiaries under the laws of a foreign jurisdiction to operate foreign businesses

The foreign sub is not part of the consolidated U.S. return

What is the impact of this type of arrangement on losses? The losses of the foreign subsidiary

cannot offset income of the parent and vice versa

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Foreign SubsidiaryForeign Subsidiary

The U.S. does not generally have the right to tax subsidiary income until it is paid back to the U.S. parent company (i.e., “repatriated”)

When a dividend is repatriated out of after-tax earnings The dividend is foreign source earnings The dividend is “grossed-up” (add back tax) to a pre-tax

amount The associated tax generates a “deemed-paid” foreign tax

credit if the US corporation owns 10% or more of the voting stock of the foreign subsidiary

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Example: Deemed-paid CreditExample: Deemed-paid Credit

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 equal to 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 $40 FTC subject to FTC limitation

If this is the only foreign source income, USCo would be limited to $35 of FTC

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Deferral of U.S. TaxDeferral of U.S. Tax

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”

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Deferral Creates Incentives Deferral Creates Incentives for Tax Avoidancefor Tax Avoidance

Tax deferral creates incentives to shift income artificially into low-rate countries (i.e.,“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

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Controlled Foreign Corporations (CFCs)Controlled Foreign Corporations (CFCs)

CFC is a foreign corporation in which U.S. shareholders own > 50% voting power or stock value

If a CFC earns certain types of income, the law treats it as if it were immediately distributed to the shareholders

Subpart F income is “artificial” because it has no commercial or economic connection to the CFC’s home country

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Controlled Foreign Corporations (CFCs)Controlled Foreign Corporations (CFCs)

Subpart F income of a CFC is taxed as constructive dividend to all U.S. shareholders >=10% stock interest Examples Foreign-based company sales income; resale out of

country with little value added passive income

Loans from CFC back to U.S. parent are treated as constructive dividends and taxed

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Transfer PricingTransfer Pricing

Where Subpart F rules do not apply, firms can engage in some income 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 transfer prices

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