2009 Pearson Education Inc Publishing as Prentice Hall

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

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

U. S. TAX OF FOREIGNRELATED TRANSACTIONS (1 of 2) ® Jurisdiction to tax ®

U. S. TAX OF FOREIGNRELATED TRANSACTIONS (1 of 2) ® Jurisdiction to tax ® Taxation of U. S. citizens & resident aliens ® Taxation of nonresident aliens ® Taxation of U. S. businesses operating abroad © 2009 Pearson Education, Inc. Publishing as Prentice 16 -2

U. S. TAX OF FOREIGNRELATED TRANSACTIONS (2 of 2) ® Tax planning considerations ®

U. S. TAX OF FOREIGNRELATED TRANSACTIONS (2 of 2) ® Tax planning considerations ® Compliance and procedural considerations ® Financial statement implications © 2009 Pearson Education, Inc. Publishing as Prentice 16 -3

Jurisdiction to Tax ® U. S. authority to tax foreign-related transactions based on 3

Jurisdiction to Tax ® U. S. authority to tax foreign-related transactions based on 3 factors Taxpayer’s country of citizenship Taxpayer’s country of residence Location where the income is earned © 2009 Pearson Education, Inc. Publishing as Prentice 16 -4

Taxation of U. S. Citizens and Resident Aliens ® U. S. citizens and resident

Taxation of U. S. Citizens and 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 credit ® Foreign earned exclusion © 2009 Pearson Education, Inc. Publishing as Prentice 16 -5

Foreign Tax Credit (FTC) (1 of 5) ® FTC permits U. S. citizens and

Foreign Tax Credit (FTC) (1 of 5) ® FTC permits U. S. citizens and residents to avoid double taxation ® FTC directly reduces U. S. tax liability ® Creditable taxes Taxes ® U. S. paid or accrued in foreign country citizens and residents eligible © 2009 Pearson Education, Inc. Publishing as Prentice 16 -6

Foreign Tax Credit (FTC) (2 of 5) ® Translation of foreign tax payments Cash

Foreign Tax Credit (FTC) (2 of 5) ® Translation of foreign tax payments Cash basis taxpayers use exchange rate on date of payment Accrual taxpayers use average exchange rate for the year © 2009 Pearson Education, Inc. Publishing as Prentice 16 -7

Foreign Tax Credit (FTC) (3 of 5) ® FTC limited to lesser of Foreign

Foreign Tax Credit (FTC) (3 of 5) ® FTC limited to lesser of Foreign tax actually paid OR foreign taxable income U. S. tax worldwide taxable income x liability © 2009 Pearson Education, Inc. Publishing as Prentice 16 -8

Foreign Tax Credit (FTC) (4 of 5) ® FTC deducted after nonrefundable credits ®

Foreign Tax Credit (FTC) (4 of 5) ® 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. C 16 -6 Used to determine numerator of FTC formula © 2009 Pearson Education, Inc. Publishing as Prentice 16 -9

Foreign Tax Credit (FTC) (5 of 5) ® Special 9 FTC limitation separate baskets

Foreign Tax Credit (FTC) (5 of 5) ® Special 9 FTC limitation separate baskets of income ¬Foreign tax credit calculated for each basket of income ¬See pages C 16 -5 and 16 -6 for partial list of baskets Excess FTC from 1 basket cannot offset excess limitation amounts in another basket © 2009 Pearson Education, Inc. Publishing as Prentice 16 -10

Foreign Earned Income Exclusion (FEI) (1 of 5) ® FEI available to U. S.

Foreign Earned Income Exclusion (FEI) (1 of 5) ® FEI available to U. S. citizens and resident aliens working abroad ® Eligibility Bona fide resident test ¬Resident of foreign country uninterrupted for entire tax year and maintain tax home in foreign country © 2009 Pearson Education, Inc. Publishing as Prentice 16 -11

Foreign Earned Income Exclusion (FEI) (2 of 5) ® Eligibility (continued) Physical presence test

Foreign Earned Income Exclusion (FEI) (2 of 5) ® 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 © 2009 Pearson Education, Inc. Publishing as Prentice 16 -12

Foreign Earned Income Exclusion (FEI) (3 of 5) ® Foreign earned income Wages, salaries,

Foreign Earned Income Exclusion (FEI) (3 of 5) ® Foreign earned income Wages, salaries, & fees as compensation for personal services actually rendered ® Amount Lesser of exclusion of ¬$87, 600, OR ¬Foreign earned income for current year, OR ¬$239. 34 ($87, 600/365 days) x no. of qualifying days in current year © 2009 Pearson Education, Inc. Publishing as Prentice 16 -13

Foreign Earned Income Exclusion (FEI) (4 of 5) ® Additional exclusion for taxable housing

Foreign Earned Income Exclusion (FEI) (4 of 5) ® Additional exclusion for taxable housing allowance Limitation 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 © 2009 Pearson Education, Inc. Publishing as Prentice 16 -14

Foreign Earned Income Exclusion (FEI) (5 of 5) ® Housing allowance exclusion (continued) Allowance

Foreign Earned Income Exclusion (FEI) (5 of 5) ® Housing allowance exclusion (continued) Allowance limited to lesser of employerprovided amount or the individual’s FEI Housing allowance exclusion reduces amount eligible for FEI exclusion ® FTC & FEI exclusion are mutually exclusive Claim either the FTC or the FEI exclusion on 16 -15 foreign earned income, but not both © 2009 Pearson Education, Inc. Publishing as Prentice

Taxation of Nonresident Aliens ® Resident/nonresident definitions ® Investment income ® Trade or business

Taxation of Nonresident Aliens ® Resident/nonresident definitions ® Investment income ® Trade or business income ® Calculating U. S. income tax © 2009 Pearson Education, Inc. Publishing as Prentice 16 -16

Resident/Nonresident Definitions (1 of 2) ® Resident aliens are taxed same as U. S.

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 © 2009 Pearson Education, Inc. Publishing as Prentice 16 -17

Resident/Nonresident Definitions (2 of 2) ® Green-card Permanent ® Physical test resident w/ “green

Resident/Nonresident Definitions (2 of 2) ® Green-card Permanent ® Physical test resident w/ “green card” visa presence test 31 days during current calendar year AND present 183 weighted average days during a 3 -year period Present ¬Current year: 1 day counted as 1 day ¬Prior year: 1 day counted as 1/3 day © 2009 Pearson Education, Inc. Publishing as Prentice 16 -18

Investment Income (1 of 2) ® Most U. S. source passive or investment income

Investment Income (1 of 2) ® Most U. S. source passive or investment income is taxed at 30% applied to gross amount U. S. payer must withhold tax ¬U. S. Tax payer responsible for tax if not withheld rate often reduced by tax treaties © 2009 Pearson Education, Inc. Publishing as Prentice 16 -19

Investment Income (2 of 2) ® Income exempt from U. S. taxation Non-USTo. B

Investment Income (2 of 2) ® Income exempt from U. S. taxation Non-USTo. B capital gains if individual physically present < 183 days during year Non-USTo. B interest from banks or other financial institutions not taxed Portfolio interest Income from casual sale of personal property © 2009 Pearson Education, Inc. Publishing as Prentice 16 -20

Trade or Business Income ® U. S. Trade or business (USTo. B) Conducting business

Trade or Business Income ® U. S. Trade or business (USTo. B) Conducting business in U. S. on regular basis with intent to make a profit ® Income 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 USTo. B instead of passive income © 2009 Pearson Education, Inc. Publishing as Prentice 16 -21

Calculating U. S. Income Tax ® Individuals Cannot must itemize deductions claim standard deduction

Calculating U. S. Income Tax ® Individuals Cannot must itemize deductions claim standard deduction ® Normal deductions apply for items “effectively connected” to a USTo. B Gains from real property considered “effected connected” to a USTo. B ® Tax treaties often reduce or eliminate U. S. for many types of income 16 -22 © 2009 Pearson Education, Inc. Publishing as Prentice

Taxation of U. S. Businesses Operating Abroad ® Domestic corps & Foreign branches ®

Taxation of U. S. Businesses Operating Abroad ® Domestic corps & Foreign branches ® Foreign corporations ® Deemed paid foreign tax credit ® Controlled foreign corporations ® Inversions ® § 482 rules and tax avoidance ® Foreign Sales Corporations & Extra- territorial Income Exclusion © 2009 Pearson Education, Inc. Publishing as Prentice 16 -23

Domestic Corporations ® Domestic subsidiary corporations Can file consolidated return w/ parent Parent protected

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) © 2009 Pearson Education, Inc. Publishing as Prentice 16 -24

Foreign Corporations domestic corp owns 10% of foreign corp, domestic corp eligible for “deemed

Foreign Corporations 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-USTo. B earnings ® U. S. tax on foreign sub’s income deferred until dividends received 16 -25 ® If © 2009 Pearson Education, Inc. Publishing as Prentice

Deemed Paid Foreign Tax Credit Separate ¬Called basket if own ≥ 10% & ≤

Deemed Paid Foreign Tax Credit Separate ¬Called basket if own ≥ 10% & ≤ 50% Sec. 902 or 10/50 dividends Div paid to domestic corp from undistrib Creditable Deemed earnings paid _________ X taxes paid or = accrued by foreign tax All undistributed foreign corp credit earnings © 2009 Pearson Education, Inc. Publishing as Prentice 16 -26

Controlled Foreign Corporations (CFC) (1 of 3) Typical tax-avoidance scenario of a CFC U.

Controlled Foreign Corporations (CFC) (1 of 3) Typical tax-avoidance scenario of a CFC U. S. Manufacturing Corporation (Chicago) Billing of tax haven sales subsidiary by U. S. manufacturer Physical flow of goods Foreign Sales Subsidiary (Island Corporation) Foreign Purchasers of U. S. Manufacturer’s Products Billing of foreign purchasers by tax haven sales subsidiary © 2009 Pearson Education, Inc. Publishing as Prentice 16 -27

Controlled Foreign Corporations (CFC) (2 of 3) ® CFC definition >50% of foreign corp

Controlled Foreign Corporations (CFC) (2 of 3) ® CFC definition >50% of foreign corp stock owned by U. S. shareholders ¬U. 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 earned See Figure C 16 -2 © 2009 Pearson Education, Inc. Publishing as Prentice 16 -28

Controlled Foreign Corporations (CFC) (3 of 3) ® Tax-deferred earnings can be taxed under

Controlled Foreign Corporations (CFC) (3 of 3) ® 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 © 2009 Pearson Education, Inc. Publishing as Prentice 16 -29

§ 482 Rules & Tax Avoidance (1 of 3) ® Tax avoidance opportunity high

§ 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) © 2009 Pearson Education, Inc. Publishing as Prentice 16 -30

§ 482 Rules & Tax Avoidance (2 of 3) ® § 482 authorizes IRS

§ 482 Rules & Tax Avoidance (2 of 3) ® § 482 authorizes IRS to distribute, apportion, or allocate gross income, deductions, credits, or allowances between or among controlled entities © 2009 Pearson Education, Inc. Publishing as Prentice 16 -31

§ 482 Rules & Tax Avoidance (3 of 3) ® § 482 Regs hold

§ 482 Rules & Tax Avoidance (3 of 3) ® § 482 Regs hold that transactions between entities must meet arm’slength standard Consistent w/ transactions between uncontrolled entities ¬Comparable transaction under comparable circumstances © 2009 Pearson Education, Inc. Publishing as Prentice 16 -32

Inversions (1 of 3) ® U. S. corps subject to U. S. tax on

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 © 2009 Pearson Education, Inc. Publishing as Prentice 16 -33

Inversions (2 of 3) ® Basics of inversions 1. U. S. corp merges into

Inversions (2 of 3) ® Basics of inversions 1. U. S. corp merges into a foreign entity or transfers its assets to a foreign entity 2. Owners of U. S. corp exchange U. S. corp’s stock for equity in foreign entity 3. Same owners continue to conduct both U. S. and foreign business through the new foreign entity, but only U. S. © 2009 Pearson Education, Inc. Publishing as Prentice 16 -34

Inversions (3 of 3) §§ 367 & 7874 added to prevent erosion of U.

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 16 -35

Tax Planning Considerations (1 of 2) ® Deduction vs. credit foreign taxes Deduction may

Tax Planning Considerations (1 of 2) ® Deduction vs. credit foreign taxes Deduction may be beneficial when taxpayer has foreign losses or when credit is limited ® Election to accrue foreign taxes Cash method taxpayers can elect to accrue foreign taxes ¬Binding for all tax years and can only be revoked with IRS consent © 2009 Pearson Education, Inc. Publishing as Prentice 16 -36

Tax Planning Considerations (2 of 2) ® Special earned income elections Taxpayers may revoke

Tax Planning Considerations (2 of 2) ® Special earned income elections Taxpayers may revoke election to exclude foreign-earned income when ¬Employed in foreign country where foreign tax rate > U. S. tax rate OR ¬Taxpayer incurs substantial loss from overseas employment © 2009 Pearson Education, Inc. Publishing as Prentice 16 -37

Compliance and Procedural Considerations (1 of 2) ® Foreign Form operations of U. S.

Compliance and Procedural Considerations (1 of 2) ® Foreign Form operations of U. S. corp 1120 Schedule N ® Foreign tax credit Form 1118 (corp), Form 1116 (individual) ® Foreign Form earned income exclusion 2555 or 2555 -EZ © 2009 Pearson Education, Inc. Publishing as Prentice 16 -38

Compliance and Procedural Considerations (2 of 2) ® Nonresident Form 1040 -NR ® Foreign

Compliance and Procedural Considerations (2 of 2) ® Nonresident Form 1040 -NR ® Foreign Form aliens corporations 1120 -F © 2009 Pearson Education, Inc. Publishing as Prentice 16 -39

Financial Statement Implications (1 of 2) ® Foreign tax credit Excess ® Deferred FTC

Financial Statement Implications (1 of 2) ® Foreign tax credit Excess ® Deferred FTC creates deferred tax asset foreign earnings Normally would create a deferred tax asset © 2009 Pearson Education, Inc. Publishing as Prentice 16 -40

Financial Statement Implications (2 of 2) ® Deferred foreign earnings (continued) SFAS No. 109

Financial Statement Implications (2 of 2) ® Deferred foreign earnings (continued) SFAS No. 109 adopts APB No. 23 exception for indefinite reinvestment ¬No deferred tax asset unless temporary difference expected to reverse in foreseeable future © 2009 Pearson Education, Inc. Publishing as Prentice 16 -41

Comments or questions about Power. Point Slides? Contact Dr. Richard Newmark at University of

Comments or questions about Power. Point Slides? Contact Dr. Richard Newmark at University of Northern Colorado’s Kenneth W. Monfort College of Business richard. [email protected] Duh. com © 2009 Pearson Education, Inc. Publishing as Prentice Hall 16 -42