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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 tax Taxation of U.S. citizens & residents Taxation of nonresidents U.S. taxation of foreign activity
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Jurisdiction to TaxJurisdiction to Tax
Taxpayer’s country of citizenship Taxpayer’s country of residence Type of income earned Location 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 credit Foreign earned exclusion
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Foreign Tax Credit (FTC)(1 of 2)
FTC permits U.S. citizens and residents to avoid double taxation
Directly reduces U.S. tax liability FTC limited to lesser of
Foreign tax actually paid OR foreign taxable income_ U.S. taxworldwide taxable income x liability– Source of income rules (used to determine
numerator) listed on page C16-6
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Foreign Tax Credit (FTC)(2 of 2)
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 4)
FEI available to U.S. citizens and resident aliens working abroad
Eligibility– Bona fide resident test
»Present in 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 4)
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 during that period Foreign earned income
– Wages, salaries, & fees as compensation for personal services actually rendered
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Foreign Earned Income Exclusion (FEI) (3 of 4)
Amount of exclusion– Lesser of
»$80,000, OR»Foreign earned income for current year, OR»$219.18 x no. of qualifying days in current year
Exclusion for taxable housing allowance– Limitation lesser of
»Actual housing amount included in income, OR»$10,842 (2002) x (qualifying days/365)
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Foreign Earned Income Exclusion (FEI) (4 of 4)
Housing allowance (continued)– Housing costs incurred in excess of $10,842 are a
for AGI deduction– 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 NonresidentsTaxation of Nonresidents(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 NonresidentsTaxation of Nonresidents(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 NonresidentsTaxation of Nonresidents(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
Income exempt from U.S. taxation– Non-USToB capital gains if individual physically
present < 183 days during year
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Taxation of NonresidentsTaxation of Nonresidents(4 of 5)(4 of 5)
Exempt income (continued)– Non-USToB interest from banks or other
financial institutions not taxed– Portfolio interest– Income from casual sale of personal
property Individuals must itemize deductions
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Taxation of NonresidentsTaxation of Nonresidents(5 of 5)(5 of 5)
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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U.S. Taxation of Foreign U.S. Taxation of Foreign ActivityActivity
Domestic corporations Foreign corporations Deemed paid foreign tax credit Controlled foreign corporations Foreign Sales Corporations Puerto Rico and U.S. possessions
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
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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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Foreign SalesCorporations (FSC) (1 of 3)
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 3)
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 3)
In July 1999, the World Trade Organization determined that FSC export incentive is an illegal export subsidy
FSC rules replaced with extraterritorial income rules– WTO considers extraterritorial income rules
an illegal export subsidy
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Puerto Rico and U.S. Possessions Corporations
Some corps operated in Puerto Rico or U.S. possession prior to 1/1/96 can qualify for tax credit that can exempt part or all of their non-U.S. income from U.S. taxation– A new Puerto Rico Economic Activity Credit
applies for tax years beginning after 12/31/1995 and before 1/1/2006
