International Taxation Introduction Howard Godfrey, Ph.D., CPA.

International Taxation

Introduction

Howard Godfrey, Ph.D., CPA

International Taxation• The U.S. imposes taxes on “worldwide” income

of U.S. taxpayers (citizens, resident aliens and corporations organized in the U.S.).• The U.S. imposes taxes on non-resident aliens

(not U.S. citizens) and non-resident entities on income earned in the U.S.• A foreign person, who becomes a U.S. resident,

is taxed like a U.S. citizen (on worldwide income).• A foreign owned corp. that is organized in this

country is subject to U.S. income taxes. Etc.

Location U.S. U.S. Res. Non-Res. Foreign

Type (Source) Citizen Corp Alien Alien Corp

Bus. U.S. ? ? ? ? ?

Rent U.S. ? ? ? ? ?

Bus. Foreign ? ? ? ? ?

Rent Foreign ? ? ? ? ?

Foreign person operating a bus. in U.S. files return.Foreign person with U.S. investment income,

may pay U.S. income tax via withholding. No Return.

Are they subject to U.S. income tax?Income

Location U.S. U.S. Res. Non-Res. Foreign

Type (Source) Citizen Corp Alien Alien Corp

Bus. U.S. ? ? ? ? ?

Rent U.S. ? ? ? ? ?

Bus. Foreign ? ? ? No No

Rent Foreign ? ? ? No No

Foreign person operating a bus. in U.S. files return.Foreign person with U.S. investment income,

may pay U.S. income tax via withholding. No Return.

Are they subject to U.S. income tax?Income

1. Intro. To International Tax 5

General Tax FormulaGross Income 110$

Deductions For A.G.I. (10) Adjusted Gross Income (AGI) 100 Exemptions (6) Regular Itemized Ded. (15) Misc. Itemized Ded. (5)

Less 2% of AGI 2 Deductible Amount (3)

Total Deductions From AGI (24) Taxable Income 76$

Notes for case for Bud• Please note that the case for Bud involves a U.S. tax person. Same principles apply for a U.S. corporation with a branch in the foreign country, or a U.S. proprietorship with a branch operation in the foreign country.

• These concepts do not apply to a foreign person with income earned in the U.S.(Alien working in U.S., etc.)

Bud is citizen of United States.He works in U.S. - 1-1-08 thru 6-30-08.He works in U.K. - last 6 months.He earns $100,000 in first 6 months.He earns $100,000 in last 6 monthsAll income is taxable (no deductions).U.S. tax rate: 40%. U.K. tax rate: 30%.

Information: Case - Bud

Please note the variety of ways the tax systems of various countries may interact with each other.In a territorial system, each country imposes taxes on income earned in its territory.In a world-wide or global system, a county taxes income earned worldwide by its citizens. This may cause income to be taxed in more than one country.Double taxation. Credits allowed, etc.

The following slides involve the taxation of income earned in the U.S. and income earned in the U.K.The tax rates are hypothetical and various assumptions are made regarding the nature of the tax systems: territorial, world-wide, etc.The examples are designed to illustrate important concepts and may not accurately reflect the tax systems actually in effect in the countries.

Territorial Systems - No Double Tax.

U.S. Citizen U.S. U.K. TotalIncome - U. S. $100 $100Income - U. K. $100 $100U.K. Taxable Income $100U.S. Taxable Income $100Tax Rates 40% 30%Income TaxIncome Tax

Amounts in $000

Territorial System - No Double Tax.

U.S. Citizen U.S. U.K. TotalIncome - U. S. $100 $100Income - U. K. $100 $100U.K. Taxable Income $100U.S. Taxable Income $100Tax Rates 40% 30%Income Tax $30Income Tax $40 $70

Amounts in $000

U.S. Citizen U.S. U.K. TotalIncome - U. S. $100 $100Income - U. K. $100 $100U.K. Taxable Income $100U.S. Taxable Income $200Tax Rates 40% 30%Income TaxIncome Tax

Amounts in $000

Global Systems - Double Taxation

U.S. Citizen U.S. U.K. TotalIncome - U. S. $100 $100Income - U. K. $100 $100U.K. Taxable Income $100U.S. Taxable Income $200Tax Rates 40% 30%Income Tax $30Income Tax $80 $110

Amounts in $000

Global Systems - Double Taxation

U.S. Citizen U.S. U.K. TotalIncome - U. S. $100 $100Income - U. K. $100 $100

U.K. Taxable Income $100 Sec.U.K. Tax Rate 30% 164(a)(3)

U.K. Income Tax $30U.K. After tax income $70U.S. Taxable Income $170U.S. Tax Rate 40%U.S. Income Tax

Global System - Foreign tax deduction

U.S. Citizen U.S. U.K. TotalIncome - U. S. $100 $100Income - U. K. $100 $100

U.K. Taxable Income $100 Sec.U.K. Tax Rate 30% 164(a)(3)

U.K. Income Tax $30U.K. After tax income $70U.S. Taxable Income $170U.S. Tax Rate 40%U.S. Income Tax $68 $98

Global System - Foreign tax deduction

Sec. 901U.S. Citizen U.S. U.K. TotalIncome - U. S. $100 $100Income - U. K. $100 $100Taxable Income $100U.K. Tax Rate 30%Income Tax-U.K. $30After tax income $70Taxable Income $200U.S. Tax RateIncome TaxForeign Tax CreditIncome Tax

Global - Foreign tax credit

Sec. 901U.S. Citizen U.S. U.K. TotalIncome - U. S. $100 $100Income - U. K. $100 $100Taxable Income $100U.K. Tax Rate 30%Income Tax-U.K. $30After tax income $70Taxable Income $200U.S. Tax Rate 40%Income Tax $80

Foreign Tax Credit ($30)

Income Tax $50 $80

Global - Foreign tax credit

U.S. Citizen U.S. U.K. TotalIncome - U. S. $100 $100Income - U. K. $100 $100U.K. Taxable Income $100U.K. Tax Rate 50%U.K. Income Tax $50U.K. After tax income $50U.S. Taxable Income $200U.S. Tax RateGross U.S. Income Tax

Foreign Tax Credit

U.S. Income Tax

Global System - Credit - U.K. Rate Higher

U.S. Citizen U.S. U.K. TotalIncome - U. S. $100 $100Income - U. K. $100 $100U.K. Taxable Income $100U.K. Tax Rate 50%U.K. Income Tax $50U.K. After tax income $50U.S. Taxable Income $200U.S. Tax Rate 40%Gross U.S. Income Tax $80

Foreign Tax Credit ($40)

U.S. Income Tax $40 $90

Global System - Credit - U.K. Rate Higher

• Note: you can repeat the slides above for a U.S. Corporation. The U.S. corporation has net income from U.S. operations of $100,000 and net income from a branch office in a foreign country.

• The same principles apply.

• Other rules apply for foreign Sub.

• Note: The first slide (results) for Bud involves him simply excluding the income earned in a foreign country. That is the essence of Sec. 911, which allows a worker in a foreign country to exclude $80,000 per year, as well as certain housing costs.

Example 16-2 Taxable Foreign U.S.

Rates/Sources Income Tax Tax

Tax Rates 30% 25%

U.S. $10,000 $2,500

Foreign $20,000 $6,000 $5,000

Totals $30,000 $7,500

Foreign Tax Cr. ?

Example 16-2 Taxable Foreign U.S.

Rates/Sources Income Tax Tax

Tax Rates 30% 25%

U.S. $10,000 $2,500

Foreign $20,000 $6,000 $5,000

Totals $30,000 $7,500

Foreign Tax Cr. $5,000

If $6,000 credit is given, then U.S.only collects 15% tax on U.S. Income.

Sec. Foreign-source

904(a) tax. income:

$ X U.S. Tax

limit World widetax. income: $

$Credit For. Tax Pd.

Limit: $ $

Foreign Tax Credit Limit

=FTCbefore FTC

Sec. Foreign-source

904(a) tax. income:

20,000$ X U.S. Tax

limit World widetax. income: $7,500

$30,000Credit For. Tax Pd.

Limit: $5,000 $6,000

Foreign Tax Credit Limit

=FTCbefore FTC

Look at Example 16-3 and the preceding formula for the tax credit limit.

What happens if she also earns some interest income in a foreign country that does not impose an income tax.

Would that cause the value of the fraction on the tax credit formula slide to be larger, leading to a larger credit limit?

No. See Tax Credit Limits – example 16-4

Baskets and separate limits for them!!!!!

Foreign SourceForeign Tax = Pre-Credit X Taxable income

Credit Limit U.S. Tax Total TaxableIncome

How to Increase the Limit?Gross Recharacterize as foreign Income source for U.S. Tax Purposes

Deductions Recharacterize as U.S. sourcefor U.S. Tax Purposes

Maximizing Foreign Tax Credit Limit (§ 904)

2004 2005 2006

Foreign

tax accrual 90,000$ 95,000$ 100,000$

Foreign tax

credit Limit 100,000 80,000 95,000

Excess credits 15,000

Excess limit 10,000 (5,000)

Example 16-3

Carryback and carryover of credits

Foreign Tax Credit - 2004

U.S. Salary 80,000$ Canadian Income 30,000

110,000$ Itemized Ded. 10,000 Exemption 12,400 (22,400)Taxable Income 87,600$ Tax 58,100 8,000

29,500 7,375 15,375$

FTC Limit - 2004Foreign Source T.I. 30,000 World-wide T.I. 87,600 Exemptions 12,400 100,000 Ratio of Foreign Income 30%Total U.S. Tax 15,375 Limit on FTC 4,613 Foreign Tax Paid 6,000

How is this result U.S. Foreign

Prevented? Corp. Branch

Taxable Income-U.S. Source 200$ Taxable Income-Foreign Source 100 100$

300 100$ Foreign Tax Rate 70%U.S. Tax Rate 20%Foreign Tax 70$ U.S. Tax 60 Foreign Tax Credit (70) Net U.S. Tax (10)$

Foreign Tax Credit(Source: Jones & Rhoades, page 263)Jefferson conducts operations in U.S. and Belgium.

U.S. Belgium Total Foreign %Taxable Income 300$ 100$ 400$ Income Tax 109 27 136 Foreign Tax Credit

Total U.S. Taxes 136$ Part of Total U.S. Tax applicableForeign Tax Credit Limit

What is the rule about carryback, etc.?

Taxable Income & Income Taxes- 2004

Foreign Tax Credit(Source: Jones & Rhoades, page 263)Jefferson conducts operations in U.S. and Belgium.

U.S. Belgium Total Foreign %Taxable Income 300$ 100$ 400$ 25%Income Tax 109 27 136 Foreign Tax Credit

Total U.S. Taxes 136$ Part of Total U.S. Tax applicable 25%Foreign Tax Credit Limit 34$

What is the rule about carryback, etc.?

Taxable Income & Income Taxes- 2004

Foreign Tax CreditJackson Corp.’s taxable income for 2006 from all of its global operations was $500,000, resulting in U.S. federal income tax of $200,000 before credits. Jackson’s taxable income from foreign sources was $125,000 during 2006. Jackson paid income taxes of $60,000 to foreign governments. What is Jackson’s foreign tax credit limitation for 2006?a. $200,000 b. $60,000 c. $50,000 d. $12,500

Sec. Foreign-source

904(a) tax. income:

$ X U.S. Tax

limit World widetax. income: $

$Credit For. Tax Pd.

Limit: $ $

FTC Limit - Jackson Corp.

=FTCbefore FTC

Sec. Foreign-source

904(a) tax. income:

125,000$ X U.S. Tax

limit World widetax. income: $200,000

$500,000Credit For. Tax Pd.

Limit: $50,000 $60,000

FTC Limit - Jackson Corp.

=FTCbefore FTC

Foreign Earned Income Exclusion

CHOOSING A DEDUCTION, CREDIT OR EXCLUSION

A taxpayer should carefully choose between: (1) a deduction for foreign income taxes,

(2) a credit on for foreign income taxes, or

(3) an exclusion of up to $80,000 of foreign earnings from U.S. gross income.

Case 1-1Case 1. A U.S. citizen has the opportunity to earn an extra $100,000, and that income is earned in a foreign country. The taxpayer’s U.S. income tax is $30,000 (marginal rate of 30%) on the foreign income and the foreign government imposes an income tax of $20,000 on that income.

Treatment Savings

Deduction for $20,000

of foreign income taxes $6,000

Income Tax Credit for $20,000

of foreign income taxes $20,000

Exclusion of $100,000

from U.S. Gross Income $30,000

Case 1-2. Summary of Tax Savings

Foreign Income of $100,00030% U.S. Rate. 20% foreign rate

Case 1-3The Code provides a deduction for foreign income taxes paid. A deduction of $20,000 for these taxes will generate a tax savings of $6,000 (30% of $20,000).

However, a tax credit for these foreign taxes will yield a savings on U.S. income tax of $20,000.

The greatest saving is realized by excluding $100,000 from U.S. income, thereby saving U.S. income tax of $30,000.

Case 1-4

Best situation is to earn tax-free income in foreign country and exclude it from the U.S. income tax computations.

Foreign Earned Income ExclusionSection 911 provides an (a): (1) exclusion of up to $80,000 of

foreign earned income (2) exclusion for foreign housing

costs by employees and (3) deduction of certain foreign

housing costs by self-employed individuals.


Sara applies for and receives a work assignment in England for Big Corp. She moved to London on 1-1-2006. She worked and lived there continuously until the middle of 2007, when she returned to the U.S. Her salary is $200,000 per year, in both 2006 and 2007. What is the amount of her foreign earned income exclusion for 2007?

a. $0 b. $40,000 c. $60,000 d. $80,000


A taxpayer working in a foreign country reports total world-wide income on Form 1040 and then takes a deduction “for AGI” for the exclusions provided by Section 911. In effect, the exclusions are taken via deductions on the Form 1040.


The terms “foreign,” “abroad” and “overseas” refer to a situation in which a taxpayer lives and works in a foreign country.


Regular Tax Rules Continue to Apply. A taxpayer working abroad is subject to all of the tax rules applicable to those living in this country, and must deal with additional rules that are uniquely applicable those with foreign income.


Regular Tax Rules Continue to Apply. Worldwide income is reported on the Form 1040, even though the foreign income may be subject to foreign income taxes as well.

Foreign Earned Income ExclusionA taxpayer working abroad is subject to the regular rules that require inclusion in income of all fringe benefits that do not qualify for exclusion under Section 132 or other sections of the code. For example, fringe benefits in the form of the right to use the employer’s property or facilities are fully taxable unless excluded under Section 119.

Foreign Earned Income ExclusionCase 1. A taxpayer lives in Japan and is employed there all year. He receives a salary of $6,000 a month. He lives rent-free in a house provided by the employer that has a fair rental value of $3,000 a month. The house is not provided for the employer’s convenience. The taxpayer has $72,000 salary from foreign sources plus $36,000 fair rental value of the house, for a total of $108,000 of foreign earned income.These amounts may be excluded as foreign housing costs or as part of foreign earned income.


Self-Employment Tax. A self-employed taxpayer is generally subject to the same rules for paying self-employment tax whether he lives in the United States or abroad.


Case 2. A consultant works abroad and qualifies for the foreign earned income exclusion. Foreign gross income is $95,000, business deductions total $27,000, and net profit is $68,000.


Case 2.

Self-employment tax is paid on all of net profit, including the amount excluded from income for regular income tax purposes (unless there is an agreement with the foreign country so that only one country imposes social security tax or S.E tax ).


Allocating Income to a Tax Year. The foreign earned income exclusion of up to $80,000 per year makes it important to accurately identify the year in which foreign income is earned.


Case 3. A taxpayer in a foreign country has tax-free income of $160,000 over a two-year period when he earns $80,000 in 2005 and $80,000 in 2006. If the same taxpayer earns $70,000 in 2005 and $90,000 in 2006, he will have tax-free income of only $150,000 in the same two year period.


Case 3. … However, assume the compensation of $90,000 received in 2006 actually included a bonus of $10,000 for service in 2005. In this case, he will qualify for an exclusion of $90,000 on the 2006 tax return – consisting of $80,000 for 2006 and $10,000 of the unused exclusion from 2005.


When working with compensation for services, it is necessary to compute the amount of gross income to be excluded, and then disallow the deductions for certain expenditures that are identified with excluded income.


Case 4. An employee works for an employer for the entire year but works in a foreign country for only 11 months of the year. Only the gross income earned in the foreign country will be excluded, up to a prorated amount of the $80,000 maximum exclusion.


Case 4 Cont’d. A deduction for unreimbursed employee expenses will be disallowed, to the extent they relate to gross income that is excluded.

Questions to Ask About Income

1. Is the income required to be included in gross income under general tax rules?

2. Is the income classified as U.S. income or foreign source income?

3. Is the income classified as earned income?

4. In what year was the income earned? (It is generally allocated to the year in which it was earned, and is subject to the annual exclusion limit for that year).


The benefits of Section 911 are available even though the foreign earned income may be tax-exempt in the foreign country. This means a U.S. citizen or resident alien working in a foreign country may earn income that is entirely free of income taxes. Investment income and other income that is not considered foreign earned income are not covered by Section 911.


Section 911(a) of the Code allows a "qualified individual," as defined in §911(d)(1), to exclude foreign earned income and housing cost amounts from gross income.

Section 911(c)(4) of the Code allows a qualified individual to deduct housing cost amounts from gross income.


Section 911(d)(1) of the Code defines the term "qualified individual" as an individual whose tax home is in a foreign country and who is

(A) a citizen of the United States and establishes to the satisfaction of the Secretary of the Treasury that the individual has been a bona fide resident of a foreign country or countries for an uninterrupted period that includes an entire taxable year, or


Section 911(d)(1) of the Code defines the term "qualified individual" as an individual whose tax home is in a foreign country and who is

---

(B) a citizen or resident of the United States who, during any period of 12 consecutive months, is present in a foreign country or countries during at least 330 full days.


26 U.S.C. §911(a)(1). "Foreign earned income" is the amount an individual receives "from sources within a foreign country ... which constitute[s] earned income attributable to services performed by such individual" during the applicable time period described in 26 U.S.C. §911(d)(1)(A) or (B).

Foreign Earned Income ExclusionUnder §911(d)(1)(A) or (B), to qualify for the exclusion, the individual's tax home must be in a foreign country and the individual must be a United States citizen who has been a bona fide resident of the foreign country for the entire tax year or a United States citizen or resident who has been present in the foreign country for at least 330 full days of twelve consecutive months. See also 26 C.F.R. §1.911-2(a).


The regulations define a "foreign country" as "any territory under the sovereignty of a government other than that of the United States," id. §1.911-2(h), and "United States" to "include any territory under the sovereignty of the United States[,]" including its "possessions and territories," id. §1.911-2(g).

Exclusion Example

The following slides contain an example that illustrates the overall procedure.

Salary earned in 2004 $100,000 Employer's housing allowance $25,000 Total foreign earned income $125,000 Actual housing costs $40,000 Housing cost threshold $11,581 Excess housing costs $28,419

Excess housing costs $28,419

Foreign income earned as employee 100%

Exclusion of excess housing costs $28,419 Foreign earned income from employment

$125,000

Earned income exclusion limit (foreign earned income, less housing exclusion)Statutory limit on exclusionLesser of two amounts aboveTotal of two exclusion amounts

Excess housing costs $28,419

Foreign income earned as employee 100%

Exclusion of excess housing costs $28,419 Foreign earned income from employment

$125,000

Earned income exclusion limit (foreign earned income, less housing exclusion)

$96,581

Statutory limit on exclusion $80,000 Lesser of two amounts above $80,000 Total of two exclusion amounts $108,419

Foreign OperationsThe easiest way for a U.S. enterprise to engage in global commerce is simply to sell U.S.-produced goods and services abroad. These sales can be conducted with little or no foreign presence and allow the business to explore foreign markets without making costly financial commitments to foreign operations.

Foreign OperationsThe U.S. tax consequences of simple export sales are straightforward. All such income is taxed in the United States to the U.S. taxpayer. Whether foreign taxes must be paid on this export income depends on the particular law of the foreign jurisdiction and whether the U.S. taxpayer is deemed to have a foreign business presence there (often called a "permanent establishment").

Foreign OperationsTax rules applicable to U.S. persons that control business operations in foreign countries depend on whether the business operations are conducted directly (through a foreign branch, for example) or indirectly (through a separate foreign corporation).

Foreign Operations

A U.S. person that conducts foreign operations directly includes the income and losses from such operations on the person's U.S. tax return for the year the income is earned or the loss is incurred.

Alt. Forms for Foreign Operations

Detailed rules are provided for the translation into U.S. currency of amounts with respect to such foreign operations. The income from the U.S. person's foreign operations thus is subject to current U.S. tax. However, the foreign tax credit may reduce or eliminate the U.S. tax on such income.


A U.S. company can enter foreign markets in a number of ways.

1. It may simply hire foreign sales representatives to market its products in other countries.

2. It may permit unrelated foreign companies to use patents, processes and trademarks that it developed through licensing arrangements.


These two alternatives involve no physical presence by the U.S. company in the foreign jurisdiction; thus, the income earned might or might not be subject to foreign taxes, depending on the applicable treaty provisions if a treaty exists.


To expand foreign operations, having a physical presence in the foreign country can become necessary.

The legal form for establishing this presence has four basic alternatives and is critical to determining the U.S. tax consequences of the resulting foreign income.

Foreign Branch OperationsFirst the U.S. corporation can simply establish a branch office in the foreign country. Such a branch is not a legal entity distinct from the U.S. Corporation; thus any income it earns is included in worldwide taxable income. If the U.S. corporation pays taxes in the foreign country on branch earnings, it can claim a foreign tax credit subject to the same rules and limits.


Second, the U.S. corporation could conduct operations in partnership with others. Its share of partnership income is subject to U.S. taxation The corporation's share of any foreign income taxes paid on partnership earnings is assed through to the corporation and is includible in its foreign tax credit.

Foreign Branch

Operations

Foreign Branch OperationsSections 985 through 989 of the Internal Revenue Code of 1986 to provide rules for the treatment of foreign currency transactions. Section 985(a) provides that, unless otherwise provided in regulations, all determinations under subtitle A of the Code shall be made in the taxpayer's functional currency (as defined in section 985(b)).


Second, the U.S. corporation could conduct operations in partnership with others. Its share of partnership income is subject to U.S. taxation The corporation's share of any foreign income taxes paid on partnership earnings is assed through to the corporation and is includible in its foreign tax credit.


The third and fourth alternatives involve the formation of a controlled subsidiary to conduct foreign operations, incorporated in either the United States or a foreign country.

Foreign Corporate Operations


Controlled Subsidiaries

For tax and nontax purposes, the U.S. corporation might wish to establish a controlled subsidiary to engage in foreign operations.

Such a subsidiary is a separate legal entity with the U.S. corporation as the controlling (often sole) shareholder.

Alt. Forms for Foreign OperationsControlled Subsidiaries In many foreign countries, legal restrictions exist on foreign ownership of property. Thus, operation through a foreign subsidiary might be the only feasible alternative. In other countries, so-called branch profits taxes could discourage the use of a branch operation and favor the establishment of a subsidiary. The optimal choice varies from country to country and situation to situation.


Taxation of the controlled subsidiary's earnings depends on whether the subsidiary is incorporated in the United States or in a foreign country.

A controlled U.S. subsidiary's income is subject to U.S. taxation when earned under general corporate tax rules.


If the controlled U.S. sub pays dividends to its parent, the dividends typically qualify for the 100 percent dividends-received deduction and thus produce no U.S. tax at the time of repatriation. The U.S. parent's consolidated tax return includes the controlled U.S. subsidiary, and the consolidated group claims a foreign tax credit related to the subsidiary's foreign income and foreign taxes paid.


A controlled foreign sub. is not an eligible corporation for purposes of consolidated return rules and thus cannot be included in the U. S. parent corporation's consolidated tax return.

However, the income of a controlled foreign subsidiary is not subject to U.S. taxation when it is earned.


Instead, earnings of a foreign subsidiary escape U.S. taxation until earnings are repatriated to the U.S., [meaning when they are paid to the U.S. parent corporation as a dividend].

The foreign jurisdiction probably taxes the income when earned and might also assess a tax on any dividend payments to the U.S. parent.


When a foreign subsidiary pays a dividend to its U.S. parent, it is paying out net earnings after paying foreign taxes. For U.S. tax purposes, the parent corporation recognizes dividend income equal to the gross earnings (before reduction by the foreign taxes paid) and then takes a deemed paid foreign tax credit for the applicable tax amount

Alt. Forms for Foreign OperationsTaxable dividend income equals the net dividend received plus any foreign withholding tax on the dividend distribution plus foreign taxes paid by the controlled foreign subsidiary on the income from which the dividend is distributed. Note that dividends received from foreign corporations are not eligible for the dividends-received deduction, so the total grossed up amount of the dividend is subject to U.S. tax.

Alt. Forms for Foreign OperationsCharlotte Corp.’s taxable income for 2006 from all of its global operations was $1,000,000, resulting in U.S. federal income tax of $340,000 before credits. Charlotte’s wholly owned subsidiary (which is incorporated in a foreign country) earned net income of $200,000 in the foreign country in 2006. Charlotte received no dividend from the foreign subsidiary in 2006, but received a dividend of $50,000 in 2007. Charlotte reports (on its U.S. corporate tax return) income of its foreign subsidiary of:a. $200,000 for 2006 b. $200,000 for 2007 c. $50,000 for 2006 d. $0 in 2006 & $0 in 2007

Alt. Forms for Foreign OperationsRepeat the preceding question, except assume that the income of the subsidiary is Subpart F income.

Charlotte reports (on its U.S. corporate tax return) income of its foreign subsidiary of:

a. $200,000 for 2006

b. $200,000 for 2007

c. $50,000 for 2007

d. $0 in 2006 and $0 in 2007

US Corp and SubsidiaryThe following slide summarizes the transactions of a U.S. parent corporation (USC) and its wholly owned subsidiary corporation organized and operating in the Cayman Islands (CSub).

Parent (USC) manufactures widgets in the U.S. & sells them to its Cayman Subsidiary (CSub).

The Cayman Subsidiary sells the widgets in other parts of the world.

Initially, we ignore transfer pricing limits and subpart F.

USC mfg. & freight costs: 500,000$ USC operating expenses: 100,000 CSub buys all widgets for: 800,000 CSub operating expenses: 100,000 CSub sells all widgets for: 1,000,000

USC (USCorp) is a domestic corp. USC makes 100,000 widgets in U.S.

U.S. tax rate: 30%. Cayman rate: 0%.

CSub does not pay dividends in 2006. Total income tax for USC & CSub?

CSub is organized in Cayman Islands. CSub is owned 100% by USC.

Cost Expense Sell. Price USC’s COGS 500,000 USC's exp. 100,000 USC S. Price 800,000 CSub COGS 800,000 CSub's exp. 100,000 CSub Rev. 1,000,000

Total USC Profit ? USC Tax ? CSub Profit ? CSub Tax ?


Total USC Profit 200,000 USC Tax 60,000 CSub Profit 100,000 CSub Tax -

USC CSub

Revenue $800,000 $1,000,000

C.O.G.S (500,000) (800,000)

Expenses (100,000) (100,000)

Profit 200,000 100,000

Tax Rate 30% 0%

Income Tax $60,000 -

What happens if we change our intercompany pricing policy, and sell the widgets to the Cayman subsidiary at our cost, so that we break-even in the United States?

USC mfg. & freight costs: 500,000$ USC operating expenses: 100,000 CSub buys all widgets for: 600,000 CSub operating expenses: 100,000 CSub sells all widgets for: 1,000,000

Total income tax for USC & CSub?

CSub is organized in Cayman Islands. CSub is owned 100% by USC.

USC (USCorp) is a domestic corp. USC makes 100,000 widgets in U.S.

U.S. tax rate: 30%. Cayman rate: 0%.

CSub does not pay dividends in 2006.


Total USC Profit ? USC Tax ? CSub Profit ? CSub Tax ?

Cost Expense Sell. Price USC’s costs 600,000 USC S. Price 600,000 CSub cost 600,000 CSub's exp. 100,000 CSub Rev. 1,000,000

Total USC Profit - USC Tax - CSub Profit 300,000 CSub Tax -

USC CSub

Revenue $600,000 $1,000,000

C.O.G.S (500,000) (600,000)

Expenses (100,000) (100,000)

Profit - 300,000

Tax Rate 30% 0%

Income Tax $0 -

Subpart FSuppose in the preceding slide, USC is actually selling its product to various customers throughout the world.The Cayman Islands sub is a sales agent (paper corporation) that technically buys from USC for $600,000 and sells to USC’s customers for $1,000,000.The products are shipped directly to USC’s customers and USC actually handles the billing, etc.If CSub does not produce in the Cayman Islands and does not sell in the Cayman Islands, Subpart F comes into play. USC is treated as receiving a distribution of CSub earnings on the last day of the year. See bottom of page 16-26

Subpart F

Suppose in the preceding slide, USC is actually selling its product to a wholly owned German Subsidiary.USC uses the Cayman Islands sub as a sales agent to buy from USC for $600,000 and sell to the German Subsidiary for $1,000,000.German subsidiary will sell the products in Germany for $1,000,000.Without transfer pricing limits or Subpart F, there would be no profit to be taxed in the U.S. or in Germany.

Transfer Pricing

The variance in tax rates and tax systems among countries, provide a strong incentive for a multinational enterprise to shift income, deductions, or tax credits among commonly controlled entities in order to arrive at a reduced overall tax burden. Such a shifting of items between commonly controlled entities could be accomplished by setting artificial transfer prices for transactions between group members.

Transfer Pricing

Assume that a U.S. corp. has a wholly-owned foreign sub.

The U.S. corp. manufactures a product domestically and sells it to the foreign subsidiary. The foreign sub., in turn, sells the product to unrelated third parties. Due to the U.S. parent's control of its subsidiary, the price which is charged by the parent to the subsidiary theoretically could be set independently of ordinary market forces.

Transfer Pricing

If the foreign sub is established in a jurisdiction that subjects its profits from the sale of the product to an effective rate of tax lower than the effective U.S. tax rate, then the U.S. corp may be inclined to undercharge the foreign subsidiary for the product.

Transfer Pricing

By doing so, a portion of the combined profits of the group from the manufacture and sale of the product would be shifted out of a high-tax jurisdiction (the U.S.) and into a lower-tax jurisdiction (the foreign corporation's home country).

Transfer Pricing

By contrast, U.S. companies owning foreign subsidiaries that are located in countries with effective tax rates that are higher than the U.S. rates may have an incentive to overcharge for sales from the U.S. parent to the foreign subsidiary in order to shift profits, and the resulting tax, into the United States. The ultimate result of this process would be a reduced worldwide tax liability of the multinational enterprise.

Transfer Pricing

Under section 482, the Secretary of the Treasury is authorized to redetermine the income of an entity subject to U.S. taxation, when it appears that an improper shifting of income between that entity and a commonly controlled entity in another country has occurred.

Now take a look at kind of double taxation.

Harold ArrowsmithThis controversy arose in connection with the estate of Harold Arrowsmith (hereinafter "decedent"), who died intestate in Germany on August 15, 1989. He was born, raised, and educated in Baltimore, Maryland and received a degree from the Johns Hopkins University in 1950. He continued to live in Maryland until 1974 when he sold his house and put his furniture in storage.

He briefly resided in an apartment-hotel in Washington, D.C., but moved to Germany in 1975. Although the decedent remained a U.S. citizen his entire life, filed U.S. income tax returns, and maintained a Maryland driver's license, he returned only occasionally to the United States to present the results of his research and writings.

His assets in Maryland consisted almost entirely of intangible personal property, specifically publicly-traded securities worth nearly $30 million, held at the Mercantile-Safe Deposit and Trust Company.

The decedent's heirs initially filed a petition for probate in Baltimore County in September 1989, asserting that because "the decedent was domiciled in Maryland and a majority of his assets are located in this state," the Register of Wills for Baltimore County (hereinafter "the Register") was the proper office in which to file the petition.

On May 14, 1990, the appellees paid $2,000,000 to the Register in inheritance taxes.

About that time, the estate also paid Maryland and Federal estate taxes, in the amount of $1,957,164 and $11,010,462, respectively.

Concurrent with the administration of the decedent's estate in the United States, parallel probate proceedings were initiated in Germany. Unable to ascertain the decedent's heirs, the German tax authorities appointed a curator to administer his estate under German law.

Concluding that at the time of his death the decedent was domiciled in Germany, the German tax authorities asserted that Germany was entitled to the inheritance taxes on his entire worldwide estate.

The total German tax assessed was approximately $17,511,145.

The German curator turned over all of the decedent's assets located in Germany, totaling $1,022,355, to the German tax authorities as partial payment of the assessed taxes, leaving an unpaid German inheritance tax balance of approximately $16,488,790, exclusive of interest and administrative penalties for failure to file timely returns or make timely payment.

What do you say?

Did you notice the grand total of taxes?

1. Intro. To International Tax 123

International Taxation Introduction Howard Godfrey, Ph.D., CPA.

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Transcript of International Taxation Introduction Howard Godfrey, Ph.D., CPA.