Chapter 16 Multijurisdictional Taxation Essentials of Taxation 2016

Chapter 16 Multijurisdictional Taxation Essentials of Taxation © 2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 1

The Big Picture (slide 1 of 3) • Voice. Co, a domestic corporation, designs, manufactures, and sells specialty microphones for use in theaters. • All of its activities take place in Florida – But, it ships products to customers all over the United States. • When it receives some inquiries about its products from foreign customers, Voice. Co decides to test the foreign market and places ads in foreign trade journals. – Soon it is taking orders from foreign customers.

The Big Picture (slide 2 of 3) • Voice. Co is concerned about its potential foreign income tax exposure. • Although it has no assets or employees in the foreign jurisdictions, it now is involved in international commerce and has many questions. – Is Voice. Co subject to income taxes in foreign countries? – Must it pay U. S. income taxes on the profits from its foreign sales? – What if Voice. Co pays taxes to other countries? • Does it receive any benefit from these payments on its U. S. tax return?

The Big Picture (slide 3 of 3) • Voice. Co establishes a manufacturing plant in Ireland. – Voice. Co incorporates the Irish operation as Voice. Co. Ireland, a controlled foreign corporation (CFC). • So long as Voice. Co-Ireland does not distribute profits to Voice. Co, will the profits escape U. S. taxation? • What are the consequences to Voice. Co of being the owner of a so-called CFC? • Read the chapter and formulate your response.

U. S. International Tax Provisions (slide 1 of 2) • Concerned primarily with two types of potential taxpayers: – U. S. persons earning income from outside the United States, and – Non-U. S. persons earning income from inside the United States 5

U. S. International Tax Provisions (slide 2 of 2) • Can be organized in terms of: – Outbound taxation • Refers to the U. S. taxation of foreign-source income earned by U. S. taxpayers – Inbound taxation • Refers to the U. S. taxation of U. S. -source income earned by foreign taxpayers 6

U. S. Taxation of Cross-Border Transactions

Sources of Law (slide 1 of 3) • U. S. individuals and companies – Subject to both U. S. law and laws of other jurisdictions in which they operate or invest • The Internal Revenue Code addresses the tax consequences of earning income anywhere in the world • Must also comply with the local tax law of the other nations in which they operate • For non-U. S. persons, U. S. statutory law is relevant to income they earn that is connected to U. S. income-producing activities 8

Sources of Law (slide 2 of 3) • Tax treaties exist between the U. S. and many other countries – All tax treaties are organized in the same way • Include provisions regarding the taxation of: – – Investment income Business profits from a permanent establishment (PE) Personal service income, and Exceptions for certain persons (e. g. , athletes, entertainers, students, and teachers) 9

Sources of Law (slide 3 of 3) • Tax treaty provisions generally override the treatment otherwise called for under the Internal Revenue Code or foreign tax statutes 10

Authority to Tax (slide 1 of 2) • The U. S. taxes U. S. taxpayers on “worldwide” income – The U. S. allows a foreign tax credit to be claimed against the U. S. tax to reduce double-taxation (U. S. and foreign) of the same income 11

Authority to Tax (slide 2 of 2) • Foreign persons may be subject to tax in the U. S. – Generally, subject to tax only on income earned within U. S. borders 12

Sourcing of Income • Determining the source of income is critical in calculating the U. S. tax consequences to both U. S. and foreign persons – Numerous tax provisions address the incomesourcing rules for all types of income • These sourcing rules generally assign income to a geographic source based on the location where the economic activity producing the income took place 13

Allocation and Apportionment of Deductions (slide 1 of 2) • Deductions and losses must be allocated and apportioned between U. S. - and foreign-source income – Deductions directly related to an activity or property are allocated to classes of income to which they directly relate – Then, deductions are apportioned between statutory and residual groupings 14

The Big Picture – Example 8 Income Sourcing (slide 1 of 2) • Return to the facts of The Big Picture on p. 16 -1. • Assume that Voice. Co makes an overseas investment and generates $2 million of gross income and a $50, 000 expense, all related to its microphone manufacturing and sales. • The expense is allocated and apportioned on the basis of gross income.

The Big Picture – Example 8 Income Sourcing (slide 2 of 2)

Allocation and Apportionment of Deductions (slide 2 of 2) • Interest expense is allocated and apportioned to all activities and property regardless of the specific purpose for incurring the debt – Allocation and apportionment is based on either FMV or tax book value of assets 17

The Big Picture – Example 9 Apportionment Of Interest Expense • Return to the facts of The Big Picture on p. 16 -1. • Assume that Voice. Co generates U. S. - source and foreign-source gross income for the current year. • Voice. Co’s assets (tax book value) are as follows. Assets generating U. S. -source income Assets generating foreign-source income $18, 000 5, 000 $23, 000 • Voice. Co incurs interest expense of $800, 000 for the current year. Using the tax book value method, interest expense is apportioned to foreign-source income as follows. $5, 000 (foreign assets) $23, 000 (total assets) X $800, 000 = $173, 913

Foreign Tax Credit • Foreign tax credit (FTC) provisions are designed to reduce the possibility of double taxation – Allows a credit foreign taxes paid or accrued • Credit is a dollar-for-dollar reduction of U. S. income tax liability – FTC may be “direct” or “indirect” • The FTC is elective for any particular tax year – If FTC is not elected, § 164 allows a deduction foreign taxes paid or incurred • Cannot take a credit and deduction for same foreign taxes • In most situations the FTC is more valuable to the taxpayer 19

Direct Foreign Tax Credit • Available to taxpayers who pay or incur a foreign income tax – Only person who bears the legal burden of the foreign tax is eligible for the direct credit • Direct credit is not available to a U. S. corporation operating in a foreign country through a foreign subsidiary 20

Indirect Foreign Tax Credit (slide 1 of 5) • The indirect credit is available to U. S. corporations for dividends received (actual or constructive) from foreign corporations – Foreign corp pays tax in foreign jurisdiction – When foreign corp remits dividends to U. S. corp, the income is subject to tax in the U. S. 21

Indirect Foreign Tax Credit (slide 2 of 5) • Foreign taxes are deemed paid by U. S. corporate shareholders in same proportion as dividends bear to foreign corp’s post-1986 undistributed E & P –Indirect FTC = Actual or constructive dividend Post-1986 undistributed E & P X Post-1986 foreign taxes • Corporations choosing the FTC for deemed-paid foreign taxes must gross up dividend income by the amount of deemed-paid taxes 22

Indirect Foreign Tax Credit (slide 3 of 5) • Example – Wren Inc, a domestic corp, receives a $120, 000 dividend from Finch Inc, a foreign corp. Finch paid $500, 000 of foreign taxes on post-1986 E & P totaling $1, 200, 000 (after taxes) 23

Indirect Foreign Tax Credit (slide 4 of 5) • Example (cont’d)-Wren’s deemed-paid foreign taxes for FTC purposes are $50, 000 Cash dividend from Finch Deemed-paid foreign taxes $500, 000 × $ 120, 000. $1, 200, 000 Gross income to Wren $120, 000 50, 000 $170, 000 – Wren includes $170, 000 in gross income for the year • As a result of the dividend received, Wren can claim a credit for the $50, 000 in deemed-paid foreign taxes 24

Indirect Foreign Tax Credit (slide 5 of 5) – Only available if domestic corp owns 10% or more of voting stock of foreign corp • Credit is available for 2 nd and 3 rd tier foreign corps if 10% ownership requirement is met at the 2 nd and 3 rd levels • Credit is also available for 4 th through 6 th tier foreign corps if additional requirements are met 25

Foreign Tax Credit Limitations (slide 1 of 3) • Limit is designed to prevent foreign taxes from being credited against U. S. taxes on U. S. -source taxable income – FTC cannot exceed the lesser of: • Actual foreign taxes paid or accrued, or • U. S. taxes (before FTC) on foreign-source taxable income, calculated as follows: U. S. tax × Foreign-source taxable income before FTC Worldwide taxable income 26

Foreign Tax Credit Limitations (slide 2 of 3) • Limitation can prevent total amount of foreign taxes paid in high-tax jurisdictions from being credited – Generating additional foreign-source income in low, or no, tax jurisdictions could alleviate this problem – However, a separate limitation must be calculated for certain categories (baskets) of foreign source income 27

Foreign Tax Credit Limitations (slide 3 of 3) • For tax years beginning after 2006, there are only two baskets: – Passive income, and – All other (general) • The FTC limitations can result in unused (noncredited) foreign taxes for the tax year which may be carried over – Carryback period is 1 year – Carryforward period is 10 years 28

The Big Picture – Example 13 Foreign Tax Credit Limit (slide 1 of 2) • Return to the facts of The Big Picture on p. 16 -1. • Assume that Voice. Co invests in the bonds of non-U. S. corporations. • Voice. Co’s worldwide taxable income for the tax year is $1, 200, 000, consisting of – $1, 000 of profits from U. S. sales, and – $200, 000 of interest income from foreign sources. • All of the foreign income is in the passive basket. • Foreign taxes of $90, 000 were withheld by tax authorities on these interest payments.

The Big Picture – Example 13 Foreign Tax Credit Limit (slide 2 of 2) • Voice. Co’s U. S. tax before the FTC is $420, 000 – $1, 200, 000 X 35%. • Its FTC is limited to $70, 000. – $420, 000 X ($200, 000/$1, 200, 000). • Thus, Voice. Co’s net U. S. tax liability on this income is $350, 000 after allowing the $70, 000 FTC. • The remaining $20, 000 ($90, 000 foreign tax paid $70, 000 FTC benefit) of foreign taxes may be carried back one year or forward 10 years, for use within the passive basket.

Controlled Foreign Corporations (slide 1 of 4) • To minimize current tax liability, taxpayers often attempt to defer the recognition of taxable income – One way to do this is to shift the income-generating activity to a foreign entity that is not within the U. S. tax jurisdiction. • A foreign corporation is the most suitable entity for such an endeavor • Because of the potential for abuse, Congress has enacted various provisions to limit the availability of deferral 31

Controlled Foreign Corporations (slide 2 of 4) • Pro rata share of Subpart F income generated by a controlled foreign corporation (CFC) is currently included in income of U. S. shareholders 32

Controlled Foreign Corporations (slide 3 of 4) • Examples of Subpart F income include: – Passive income such as interest, dividends, rents, and royalties – Sales income where neither the manufacturing activity nor the customer base is in the CFC’s country and either the property supplier or the customer is related to the CFC – Service income where the CFC is providing services on behalf of its U. S. owners outside the CFC’s country 33

Controlled Foreign Corporations (slide 4 of 4) • A CFC is any foreign corp in which > 50% of total voting power or value is owned by U. S. shareholders on any day of tax year – U. S. shareholder is a U. S. person who owns (directly or indirectly) 10% or more of voting stock of the foreign corp 34

Transfer Pricing Example (slide 1 of 3) • § 482 gives the IRS the power to reallocate income, deductions, credits or allowances between or among related persons when – Necessary to prevent the evasion of taxes, or – To reflect income more clearly • The IRS can use this power to address perceived abuses, as reflected in the following transfer pricing example. 35

Transfer Pricing Example (slide 2 of 3) 36

Transfer Pricing Example (slide 3 of 3) 37

Inbound Issues (slide 1 of 2) • Generally, only the U. S. -source income of nonresident alien individuals and foreign corporations is subject to U. S. taxation – A person is treated as a resident of the U. S. for income tax purposes if he or she meets either: • The green card test, or • The substantial presence test – If either test is met, the individual is deemed a U. S. resident for the year – A foreign corp is one that is not domestic 38

Inbound Issues (slide 1 of 2) • Generally, only the U. S. -source income of nonresident alien individuals and foreign corporations is subject to U. S. taxation – A person is treated as a resident of the U. S. for income tax purposes if he or she meets either: • The green card test, or • The substantial presence test – If either test is met, the individual is deemed a U. S. resident for the year – A foreign corp is one that is not domestic 39

Inbound Issues (slide 1 of 2) • Generally, only the U. S. -source income of nonresident alien individuals and foreign corporations is subject to U. S. taxation – A person is treated as a resident of the U. S. for income tax purposes if he or she meets either: • The green card test, or • The substantial presence test – If either test is met, the individual is deemed a U. S. resident for the year – A foreign corp is one that is not domestic 40

Inbound Issues (slide 2 of 2) • The United States may also tax the foreignsource income of nonresident alien individuals and foreign corporations when that income is effectively connected with the conduct of a U. S. trade or business. 41

U. S. Taxation of Nonresident Aliens (slide 1 of 3) • Non-resident alien income not “effectively connected” with U. S. trade or business – Includes dividends, interest, rents, royalties, etc – 30% tax must be withheld by payor of income, unless this rate is reduced by treaty with the payee’s country of residence • No deductions can offset this income 42

U. S. Taxation of Nonresident Aliens (slide 2 of 3) • Example: German resident earns $1, 000 dividend from U. S. corporation – Absent a U. S. -German treaty, $300 U. S. tax is withheld, and the German resident receives $700 • Treaties frequently reduce the withholding rates on dividends and interest – The payor corporation remits the tax to the IRS 43

U. S. Taxation of Nonresident Aliens (slide 3 of 3) • Non-resident alien income effectively connected with U. S. trade or business – This income is taxed at the same rates that apply to U. S. citizens – Deductions for expenses related to the income may be claimed 44

U. S. Taxation of Nonresident Aliens (slide 3 of 3) • Non-resident alien income effectively connected with U. S. trade or business – This income is taxed at the same rates that apply to U. S. citizens – Deductions for expenses related to the income may be claimed 45

U. S. Taxation of Nonresident Aliens (slide 3 of 3) • Non-resident alien income effectively connected with U. S. trade or business – This income is taxed at the same rates that apply to U. S. citizens – Deductions for expenses related to the income may be claimed 46

U. S. Taxation of Nonresident Aliens (slide 3 of 3) • Non-resident alien income effectively connected with U. S. trade or business – This income is taxed at the same rates that apply to U. S. citizens – Deductions for expenses related to the income may be claimed 47

State Income Taxation • 46 states and District of Columbia impose a tax based on corp’s taxable income – Majority of states “piggyback” onto Federal income tax base • Essentially, they have adopted part or all of the Federal tax provisions 48

UDITPA and the Multistate Tax Commission • Uniform Division of Income for Tax Purposes Act (UDITPA) is a model law relating to assignment of income among states for multistate corps • Many states have adopted UDITPA either by joining the Multistate Tax Commission or modeling their laws after UDITPA 49

UDITPA and the Multistate Tax Commission • Uniform Division of Income for Tax Purposes Act (UDITPA) is a model law relating to assignment of income among states for multistate corps • Many states have adopted UDITPA either by joining the Multistate Tax Commission or modeling their laws after UDITPA 50

Nexus for Income Tax Purposes (slide 1 of 2) • Nexus is the degree of business activity which must be present before a state can impose tax on an out-of-state entity’s income • Sufficient nexus typically exists if: – Income is derived from within state – Property is owned or leased in state – Persons are employed in state – Physical or financial capital is located in state 51

Nexus for Income Tax Purposes (slide 2 of 2) • No nexus if only “connection” to state is solicitation for sale of tangible personal property, with orders sent outside state for approval and shipping to customer (Public Law 86 -272) • Sales tax can still apply 52

Computing State Income Tax Liability 53

State Modifications (slide 1 of 2) • State modification items come about because each state creates its own tax base – Some of the rules adopted may differ from those used in the Internal Revenue Code • State modification items reflect such differences, for example – The state might allow a different cost recovery schedule – The state might tax interest income from its own bonds or from those of other states 54

State Modifications (slide 2 of 2) • State modification examples (cont’d) – The state might allow a deduction for Federal income taxes paid – The state might disallow a deduction for payment of its own income taxes – The state might allow a net operating loss (NOL) deduction only for losses generated in the state – The state’s NOL deduction might reflect different carryover periods than Federal law allows 55

Allocation and Apportionment of Income (slide 1 of 3) • Apportionment is the means by which business income is divided among states in which it conducts business – Corp determines net income for the company as a whole and then apportions some to a given state, according to an approved formula 56

Allocation and Apportionment of Income (slide 2 of 3) • Allocation is a method used to directly assign specific components of a corp’s income, net of related expenses, to a specific state • Allocable income generally includes: • Income or loss from sale of nonbusiness property • Income or losses from rents or royalties from nonbusiness real or tangible personal property 57

Allocation and Apportionment of Income (slide 3 of 3) • Typically, allocable income (loss) is removed from corporate net income before the state’s apportionment formula is applied – Nonapportionable income (loss) assigned to a state is then combined with income apportionable to the state to arrive at total income subject to tax in the state 58

Apportionment Procedure • Business income is assigned to states using an apportionment formula – Business income arises from the regular course of business • Integral part of taxpayer’s regular business • Nonbusiness income is apportioned or allocated to the state in which the incomeproducing asset is located 59

Apportionment Factors • Apportionment formulas vary among states – Traditionally, states use a three-factor formula that equally weights sales, property, and payroll – Many states use a modified formula where sales factor receives a larger weight • Tends to pull larger amount of out-of state corporation's income into the state • May provide tax relief to corps domiciled in the state 60

Sales Factor (slide 1 of 3) • Sales factor is a fraction – Numerator is corp’s sales in the state – Denominator is corp’s total sales everywhere • Most states follow UDITPA’s “ultimate destination concept” – Tangible asset sales are assumed to take place at point of delivery, not where shipping originates 61

Sales Factor (slide 2 of 3) – Dock sales occur when delivery is taken at seller’s shipping dock • Most states apply the destination test to dock sales – If purchaser has out-of-state location to which it returns with the product, sale is assigned to purchaser’s state 62

Sales Factor (slide 3 of 3) – Throwback rule • If adopted by state, requires that out-of-state sales not subject to tax in destination state be pulled back into origination state • Treats such sales as in-state sales of the origination state • Also applies if purchaser is U. S. government 63

Payroll Factor (slide 1 of 3) • Payroll factor is a fraction – Numerator is compensation paid within a state – Denominator is total compensation paid by the corporation 64

Payroll Factor (slide 2 of 3) • Compensation includes wages, salaries, commissions, taxable fringe benefits, etc – Some states exclude amounts paid to corporate officers – Some states exclude deferred compensation amounts (e. g. , 401(k) plans) 65

Payroll Factor (slide 3 of 3) • Only compensation related to production of apportionable income is included in payroll factor – In states that distinguish between business and nonbusiness income, compensation related to nonbusiness income is not included – Compensation related to both business and nonbusiness income is prorated between the two 66

Property Factor (slide 1 of 3) • Property factor generally includes average value of real and tangible personal property owned or rented – Numerator is amount used in the state – Denominator is all of corp’s property owned or rented 67

Property Factor (slide 2 of 3) • Property includes: – Land, buildings, machinery, inventory, etc – May include construction in progress, offshore property, outer space property (satellites), and partnership property • Property in transit is included in numerator of destination state 68

Property Factor (slide 3 of 3) • Property is typically valued at average historical cost plus additions and improvements – Some states allow net book value or adjusted basis to be used • Leased property, when included in the property factor, is valued at eight times its annual rental payments 69

Allocation, Apportionment Example Total allocable income (State A) $100, 000 Apportionable income (States A and B) 800, 000 Total income $900, 000 All sales, payroll, and property is divided equally between states A and B. Both states use identical apportionment formulas. Taxable income: State A State B 1/2 Apportionable income $400, 000 Allocable income 100, 000 -0 Total state taxable income $500, 000 $400, 000 70

Apportionment Example (slide 1 of 2) Americo, Inc. operates in three states with the following apportionment systems: W's factors: average of four factors, sales double-weighted X's factors: average of three factors, equally weighted Y's factors: sales factor only State: Sales: Factor Payroll: Factor Property: Factor W $400, 000 40% 90, 000 30% 120, 000 30% X $100, 000 10% 150, 000 50% 240, 000 60% Y $500, 000 50% 60, 000 20% 40, 000 10% Total $1, 000 300, 000 400, 000 71

Apportionment Example (slide 2 of 2) Taxable income for year (all states) $100, 000 State: Sales Payroll Property Total Average Taxable income to each state Total taxed in all states: N/A=not applicable X 10% N/A 50% 60% 120% 40% W 40% 30% 140% 35% $35, 000 $125, 000 $40, 000 Y 50% N/A N/A 50% $50, 000 72

Apportionment Example Revisited (slide 1 of 2) Americo, Inc. moves most personnel and property to state Y. State: W X Y Total Sales: $400, 000 $100, 000 $500, 000 $1, 000 Factor 40% 10% 50% Payroll: 30, 000 240, 000 300, 000 Factor 10% 80% Property: 40, 000 320, 000 400, 000 Factor 10% 80% W's factors: average of four factors, sales double-weighted X's factors: average of three factors, equally weighted Y's factors: sales factor only 73

Apportionment Example Revisited (slide 2 of 2) Taxable income for year (all states) $100, 000 State: W Sales: 40% Sales 40% Payroll: 10% Property: 10% Total 100% Average 25% Taxable income to each state $25, 000 Total taxed in all states: $85, 000 N/A = not applicable X 10% N/A 10% 30% 10% $10, 000 Y 50% N/A N/A 50% $50, 000 74

Unitary Taxation (slide 1 of 2) • Theory: operating divisions are interdependent so cannot be segregated into separate units – Each unit deemed to contribute to overall profits – Unitary theory ignores separate legal existence of companies: all combined for apportionment 75

Unitary Taxation (slide 2 of 2) • For multistate apportionment, all divisions or entities are treated as single unitary base: – Larger apportionment base (all companies’ activities) – Smaller apportionment factors (each state’s %) 76

Refocus On The Big Picture (slide 1 of 3) • Now you can address the questions about Voice. Co’s activities that were posed at the beginning of the chapter. • Simply selling into a foreign jurisdiction probably will not trigger any overseas income tax consequences – But, such income is taxed currently to Voice. Co in the United States.

Refocus On The Big Picture (slide 2 of 3) • When Voice. Co sets up a CFC in Ireland, it benefits from deferral. – As long as the income is not distributed to Voice. Co and as long as the income is not ‘‘tainted’’ Subpart F income, Voice. Co can avoid taxes on the profits of Voice. Co-Ireland. – If Voice. Co receives dividends from its foreign subsidiary, it can claim foreign tax credits, which help alleviate the double taxation that would otherwise result.

Refocus On The Big Picture (slide 3 of 3) What If? • Voice. Co is considering building a new manufacturing facility in another state in the United States. – How will Voice. Co’s expansion decision be affected by state tax considerations? • In making the decision to expand, Voice. Co should consider a variety of state tax issues including: – Whether the state imposes a corporate income tax at all and, if so, – Whether the state requires unitary reporting. • Other relevant issues affecting the tax calculation in the state include: – The apportionment formula used by the state, and – Whether the state has a throwback rule.

If you have any comments or suggestions concerning this Power. Point Presentation for South-Western Federal Taxation, please contact: Dr. Donald R. Trippeer, CPA trippedr@oneonta. edu SUNY Oneonta © 2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 80