Module 6 Taxation Of Foreign Taxpayers

1

Taxation of Foreign Taxpayers

Presented by

Edward Umling, CPA, LLM

August 17 – 18, 2009

General Overview

The United States asserts jurisdiction to tax income whenever it considers the income to be from sources within the United States; (i.e., to have some nexus or connection with the United States that justifies taxation),

even if the income is earned by a foreign corporation not subject to U.S. residence-based taxing jurisdiction.

See II-1

from U.S. Sources

Foreign Corporation

Income Earned

Two types of income are subject to tax

Income Effectively ConnectedIncome Not ECI (i.e. FADP)

See II-1

Fixed and Determinable Annual Period Income

this term “is merely descriptive of the character or class of income,” whether or not paid in a lump sum, a statement inspired largely by the decision in CIR v. Wodehouse/

This is basically passive income (i.e. rents royalties, dividends and interest

If the transaction constitutes a sale or

exchange, gain will not be taxable provided it is not effectively

connected with a U.S. business.

How are the two types of income taxed

If its ECI its taxed at progressive rates If its is FADP its taxed at a flat 30% rate unless

reduced by a treaty

Exceptions

Interest on Bank deposits exempt Interest on securities Capital gains if they are not ECI Sale or exchanges of 471 property (trading with

the U.S. v. Trading in the U.S.)

See II-2

Sales of U.S. Real Property

Nonresident alien individuals and foreign corporations are subject to tax on realized gain from the disposition of an interest in U.S. real property, held directly or indirectly. The gain is taxed as if it were effectively connected with the conduct of a U.S. trade or business, whether or not the foreign person is in fact engaged in a U.S. trade or business during the taxable year (§897)

The Foreign Investment in Real Property Tax Act (FIRPTA)

The characterization of property as real property for purposes of this source rule generally depends on local law. FIRPTA provides an exception to this rule. For purposes of applying the source rule to property covered by FIRPTA, real property includes certain personal assets such as stock ownership, partnership interests, and other indirect interests in real property owned by foreign persons (§897(c))

See II-9

Foreign Investment in Real PropertyPolicy Overview

Before 1980 foreign investors realized gains on the sale of real property tax free.

Congress responded by enacting Foreign Investment in Real Property Act (“FIRPA”)

This law basically treats gains realized on sales of real property located in the U.S. as ECI.

Example II-2

Foreign Company received Royalties

Analysis Represents “FADP” subject to 30% unless

reduced by treaty. Go to Article 12.

Example II-2

Foreign Company received Dividends



Example II-2

Foreign Company received Interest



Example II-2

Foreign Company received Royalties



“PE” Established

The Company send a salesman in the U.S. for two months and takes orders for 200 cars and title passes in the U.S.

Analysis of Remaining Answer

Trading with the U.S. v. Trading “In” the (U.S. Article 5 ¶ 5 Determines Taxability)

Title Passage Rule under 863(B). Income sourcing rules 1) Books of accounting method 2) IFP method 3) 50/50 method.

Debrief

Income derived from U.S. sources is taxed at progressive rates

FADP is taxed at the lower of the treaty rate or 30%

Portfolio interest – exempt Interest on securities exempt Sale of 471 property exempt Real Property – treated as ECI

Branch Profits Tax I.R.C. §884Policy Overview

Prior to the Tax Reform Act of 1986 (TRA), foreign corporations could face significantly different tax consequences on the distribution of U.S. profits.

See II-6

Policy Overview

A domestic subsidiary was subject to a 30% (or lower treaty rate) withholding tax on the remittance of earnings to its parent.

By Contrast, Profits from a branch office, however, could be repatriated to the foreign home office without being subject to the additional withholding tax.

Policy Overview

To eliminate the disparity, the TRA created Sec. 884, imposing the so-called branch profits tax (BPT).

Sec. 884 attempts to put a foreign branch operation on the same tax footing as a foreign subsidiary. This is accomplished by determining the amount of U.S. earnings theoretically "repatriated" to the foreign parent/shareholders by the branch.

See II-6

Policy Overview

To determine this amount, Sec. 884 looks to the "U.S. net equity" of the branch at the beginning and end of the tax year. If this amount has decreased (and is not attributable to an operating loss), there is deemed to have been a repatriation of funds.

See II-6

Earnings Stripping Rules Policy Overview Sec. 163(j)

Enacted by the Revenue Reconciliation Act of 1989, placed substantial restrictions on the amount of certain related-party interest expense deductions a foreign-owned U.S. corporation may take in computing its income tax (the so-called earnings stripping rules).


These rules were enacted in response to what was perceived as an erosion of the U.S. tax base through interest expense deductions.

The earnings stripping rules generally apply to a corporation with a debt-to-equity ratio in excess of 1.5 to 1;


These rules were enacted in response to what was perceived as an erosion of the U.S. tax base through interest expense deductions.

The earnings stripping rules generally apply to a corporation with a debt-to-equity ratio in excess of 1.5 to 1;

See II-7

Example Overview

US Co

Needs 5M to capitalize

Debt or Equity ?

Example Overview

US Co

Equity 50,000Debt 4,950,000

Has the effect of reducing U.S. taxes for the interest expense deduction. Moreover the payment to the parent usually had nil withholding.

163(j) Comes along and does two things

Disallows the U.S. companies excess interest expense as a current deduction where the interest is paid to a related person

Requires a minimum capital structure of debt to equity

Excess interest – interest that exceeds 50% of taxable income

Example II-8 Interest to UK 100,000 Unrelated 60,000

160,000

Interest Income 70,000Interest Expense 90,000

Taxable Income 50,000Add Back 90,000

Adjusted Taxable Income 140,000

Example II-8

Interest Income 70,000Interest Expense 90,000

Taxable Income 50,000Add Back 90,000

Adjusted Taxable Income 140,000

70,000 90,000

20,000

50%

Documents

Module 6 Taxation Of Foreign Taxpayers