16-1 ©2009 Pearson Education, Inc. Publishing as Prentice Hall

16-1©2009 Pearson Education, Inc. Publishing as Prentice Hall

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U.S. TAX OF FOREIGN-U.S. TAX OF FOREIGN-RELATED TRANSACTIONSRELATED TRANSACTIONS (1 (1

of 2)of 2)

Jurisdiction to taxTaxation of U.S. citizens &

resident aliensTaxation of nonresident aliensTaxation of U.S. businesses

operating abroad

©2009 Pearson Education, Inc. Publishing as Prentice Hall

16-3

U.S. TAX OF FOREIGN-U.S. TAX OF FOREIGN-RELATED TRANSACTIONSRELATED TRANSACTIONS (2 (2

of 2)of 2)

Tax planning considerationsCompliance and procedural

considerationsFinancial statement implications


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Jurisdiction to TaxJurisdiction to Tax

U.S. authority to tax foreign-related transactions based on 3 factorsTaxpayer’s country of citizenshipTaxpayer’s country of residenceLocation where the income is

earned


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Taxation of U.S. Citizens Taxation of U.S. Citizens and Resident Aliensand Resident Aliens

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


16-6

Foreign Tax Credit (FTC)(1 of 5)

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

FTC directly reduces U.S. tax liabilityCreditable taxes

Taxes paid or accrued in foreign countryU.S. citizens and residents eligible


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Translation of foreign tax paymentsCash basis taxpayers use exchange

rate on date of paymentAccrual taxpayers use average

exchange rate for the year


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FTC limited to lesser of Foreign tax actually paid OR

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


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FTC deducted after nonrefundable credits

Unused FTC carried back 1 year and forward 10 years on a FIFO basis to a year where taxpayer has an excess credit limitation

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

formula


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Special FTC limitation9 separate baskets of income

Foreign tax credit calculated for each basket of income

See pages C16-5 and 16-6 for partial list of baskets

Excess FTC from 1 basket cannot offset excess limitation amounts in another basket


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Foreign Earned Income Exclusion (FEI) (1 of 5)

FEI available to U.S. citizens and resident aliens working abroad

EligibilityBona fide resident test

Resident of foreign country uninterrupted for entire tax year and maintain tax home in foreign country


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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 incomeWages, salaries, & fees as compensation

for personal services actually renderedAmount of exclusion

Lesser of $87,600, ORForeign earned income for current year, OR$239.34 ($87,600/365 days) x no. of

qualifying days in current year


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Additional exclusion for taxable housing allowanceLimitation lesser of

Actual housing amount included in income, OR$14,016* ($38.30) x (qualifying days/365)

Housing costs incurred in excess of $14,016 are for an AGI deduction if not provided by employer

*Estimated at time of publication


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Housing allowance exclusion (continued)Allowance limited to lesser of employer-

provided amount or the individual’s FEIHousing allowance exclusion reduces amount

eligible for FEI exclusionFTC & FEI exclusion are mutually exclusive

Claim either the FTC or the FEI exclusion on foreign earned income, but not both


16-16

Taxation of Nonresident Taxation of Nonresident AliensAliens

Resident/nonresident definitionsInvestment incomeTrade or business incomeCalculating U.S. income tax


16-17

Resident/Nonresident Definitions (1 of 2)

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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Resident/Nonresident Definitions (2 of 2)

Green-card testPermanent resident w/ “green card” visa

Physical presence testPresent 31 days during current calendar

year AND present 183 weighted average days during a 3-year periodCurrent year: 1 day counted as 1 dayPrior year: 1 day counted as 1/3 day 2nd prior year: 1 day counted as 1/6 day


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Investment Income(1 of 2)

Most U.S. source passive or investment income is taxed at 30%30% applied to gross amountU.S. payer must withhold tax

U.S. payer responsible for tax if not withheld

Tax rate often reduced by tax treaties


16-20

Investment Income(2 of 2)

Income exempt from U.S. taxationNon-USToB capital gains if individual

physically present < 183 days during yearNon-USToB interest from banks or other

financial institutions not taxedPortfolio interestIncome from casual sale of personal

property


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Trade or Business Income

U.S. Trade or business (USToB)Conducting business in U.S. on regular

basis with intent to make a profitIncome exempt from U.S. tax if

In U.S. < 90 days/yr, employed by nonresident entity, and earn < $3,000

Real estate income may be treated as USToB instead of passive income


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Calculating U.S. Income Tax

Individuals must itemize deductionsCannot claim standard deduction

Normal deductions apply for items “effectively connected” to a USToBGains from real property considered

“effected connected” to a USToBTax treaties often reduce or eliminate

U.S. for many types of income


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Taxation of U.S. Taxation of U.S. Businesses Operating Businesses Operating

AbroadAbroad

Domestic corps & Foreign branchesForeign corporationsDeemed paid foreign tax creditControlled foreign corporationsInversions§482 rules and tax avoidanceForeign Sales Corporations & Extra-

territorial Income Exclusion


16-24

Domestic Corporations

Domestic subsidiary corporationsCan file consolidated return w/ parentParent protected from foreign creditors

of subsidiaryForeign branches

Income and losses taxed currentlyEligible for direct FTC (described earlier)


16-25

Foreign Corporations

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

10% domestic corp owner cannot claim DRD on non-USToB earnings

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


16-26

Deemed Paid Foreign Tax Credit

Separate basket if own ≥ 10% & ≤ 50%Called Sec. 902 or 10/50 dividends

Div paid to domestic corp from undistrib

earnings

All undistributed

earnings

XCreditable taxes paid or accrued by foreign

corp

=Deemed

paid foreign

tax credit


__________________

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Controlled ForeignCorporations (CFC) (1 of 3)

Typical tax-avoidance scenario of a CFC

U.S.

ManufacturingCorporation

(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


16-28


CFC definition>50% of foreign corp stock owned by U.S.

shareholdersU.S. shareholder defined if owns 10% of

stock

Some income forms (Subpart F income) of the CFC are taxed in the year in which they are earnedSee Figure C16-2


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Tax-deferred earnings can be taxed under Subpart F when invested in U.S. property

Previously taxed income distributed tax-free

Special rules apply to the sale or exchange of CFC stock


16-30

§482 Rules & Tax Avoidance(1 of 3)

Tax avoidance opportunity high for domestic parent and 100% owned subsidiary (see slide 16-26)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 authorizes IRS to distribute, apportion, or allocate gross income, deductions, credits, or allowances between or among controlled entities


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§482 Regs hold that transactions between entities must meet arm’s-length standardConsistent w/ transactions

between uncontrolled entitiesComparable transaction under

comparable circumstances


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Inversions (1 of 3)

U.S. corps subject to U.S. tax on worldwide (WW) income, while foreign corps only taxed on U.S. source income

This encourages U.S. corps with substantial foreign-source income to reorganize in a foreign country through an inversion


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Inversions (2 of 3)

Basics of inversions1.U.S. corp merges into a foreign entity or

transfers its assets to a foreign entity2.Owners of U.S. corp exchange U.S. corp’s

stock for equity in foreign entity3.Same owners continue to conduct both

U.S. and foreign business through the new foreign entity, but only U.S. source business subject to U.S. taxation


16-35

Inversions (3 of 3)

§§367 & 7874 added to prevent erosion of U.S. tax base

Under §367 a foreign corp (FC) will be deemed to be a U.S. corp if

FC acquired all assets of U.S. corp Former U.S. corp s/hs own ≥80% of

FC & FC does not conduct much business

in foreign country of incorporation©2009 Pearson Education, Inc. Publishing as

Prentice Hall

16-36

Tax Planning Tax Planning ConsiderationsConsiderations

(1 of 2)(1 of 2)

Deduction vs. credit for foreign taxesDeduction may be beneficial when

taxpayer has foreign losses or when credit is limited

Election to accrue foreign taxesCash method taxpayers can elect to

accrue foreign taxesBinding for all tax years and can only be

revoked with IRS consent


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Tax Planning Tax Planning ConsiderationsConsiderations

(2 of 2)(2 of 2)

Special earned income electionsTaxpayers may revoke election to

exclude foreign-earned income whenEmployed in foreign country where

foreign tax rate > U.S. tax rate ORTaxpayer incurs substantial loss from

overseas employment


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Compliance and Compliance and Procedural Procedural

Considerations Considerations (1 of 2)(1 of 2)

Foreign operations of U.S. corpForm 1120 Schedule N

Foreign tax creditForm 1118 (corp), Form 1116

(individual)Foreign earned income exclusion

Form 2555 or 2555-EZ


16-39

Compliance and Compliance and Procedural Procedural

Considerations Considerations (2 of 2)(2 of 2)

Nonresident aliens Form 1040-NR

Foreign corporationsForm 1120-F


16-40

Financial Statement Financial Statement Implications Implications (1 of 2)(1 of 2)

Foreign tax creditExcess FTC creates deferred tax

assetDeferred foreign earnings

Normally would create a deferred tax asset


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Financial Statement Financial Statement Implications Implications (2 of 2)(2 of 2)

Deferred foreign earnings (continued)SFAS No. 109 adopts APB No. 23

exception for indefinite reinvestmentNo deferred tax asset unless

temporary difference expected to reverse in foreseeable future


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16-1 ©2009 Pearson Education, Inc. Publishing as Prentice Hall