States Thinking Globally Taxation of Foreign Source Income

Transcription

1 States Thinking Globally Taxation of Foreign Source Income Alysse McLoughlin McDermott Will & Emery New York, NY Beverly Luther Ameriprise Financial, Inc. Minneapolis, MN Institute for Professionals in Taxation: 2016 Income Tax Symposium Tucson, Arizona November 14, 2016

2 Alysse McLoughlin ALYSSE MCLOUGHLIN is a partner in the law firm of McDermott Will & Emery LLP and is based in the Firm's New York office. She focuses her practice on state and local tax matters, with particular skill working with financial services companies. Ms. McLoughlin was most recently the head of state tax at Barclays, where she was responsible for all state taxes, including income, franchise, sales and use, and excise tax issues. Her responsibilities included establishment of state tax return filing positions and reserves, participation in the financial statement process, and the handling of all state tax audits. She has also held positions as state tax counsel at Lehman Brothers and attorney in the chief counsel division of the Internal Revenue Service. Ms. McLoughlin received her LL.M. from New York University School of Law and her J.D. from Fordham University School of Law. She earned her B.A. from the State University of New York at Binghamton. Alysse is admitted to practice in New York and New Jersey.

3 Beverly Luther Beverly Luther ( Bev ) is Counsel for Ameriprise Financial, Inc. in Minneapolis where she practices international taxation. Her work focuses on international tax planning, withholding and reporting compliance, employee global mobility, and client document review. Bev has also worked in public accounting at Deloitte Tax LLP. Bev received her B.A. in Economics from Wellesley College, her law degree from the University of Minnesota Law School and an L.L.M. in Taxation from New York University. She is licensed to practice in Minnesota.

4 State Taxation of Foreign Commerce US Taxation of Foreign Source Income Foreign Commerce Clause and Jurisdiction Tax Base Apportionment Filing Methods Tax Haven legislation Transfer pricing adjustments Inversion Regulations OECD Base Erosion and Profits Shifting ( BEPS ) 2

5 US Taxation of Foreign Source Income Systems of Taxation: Worldwide v. Territorial International Taxing Rights origins: US Constitution, Art I, 8, Cl. 1: The Congress shall have power to lay and collect taxes... While there is no stated limit on our ability to tax foreign persons, there must be an economic allegiance to the US to justify taxation per international customs International Taxing rights in the US are based on: (1) Source of Income (2) Residence of Taxpayer 5

6 US Taxation of Foreign Source Income Various ways the US imposes tax on the income of foreign persons: Effectively Connected Income or ECI Income of a foreign person that is effectively connected with a US trade or business may be taxed in the US Withholding on payments made to foreign persons Fixed, Determinable, Annual, or Periodic payments ( FDAP ) or gross proceeds from the US to a foreign person may be subject to withholding tax in the US Distributions and Deemed Distributions to US Persons Actual distributions from a subsidiary or deemed distributions from a controlled foreign corporation will be included currently in US income 6

7 US Taxation of Foreign Source Income 7 Taxation through Presence: Effectively Connected Income or ECI of a foreign person that is engaged in a US trade or business may be taxed in the US A Foreign Person Engaged in a US Trade or Business : Regular, continuous, considerable activities Only the income that is Effectively Connected to the US Trade or Business is subject to taxation FIRPTA / Dispositions of US Real Property Interests = ECI Permanent Establishments or PE Generally: a fixed place of business through which an enterprise carries on a business such as an office, branch, or factory Activities of a dependent agent who habitually exercises the power to enter into binding contracts Services PE

8 US Taxation of Foreign Source Income Non-residents may also be taxed on their US source income through withholding Chapter 3 Foreign Withholding: Nonresidents are taxed 30% on their gross Fixed, Determinable, Annual, or Periodic ( FDAP ) income sourced within the US Chapter 4 FATCA Withholding Nonparticipating Foreign Financial Institutions are taxed 30% on their FDAP income and Gross Proceeds sourced within the US 8

9 US Taxation of Foreign Source Income Taxation through Distributions or Deemed Distribution Dividends from foreign subsidiaries to US companies are taxed in the US An Indirect Foreign Tax Credit is allowed for taxes paid on foreign income if the US taxpayer owns 10% or more of a corporation. Dividends from the foreign corporation are grossed up for the foreign taxes deemed paid by the corporation on that income ( 78 gross up) Controlled Foreign Corporations may also be deemed to distribute income that is currently taxable in the US, such as: Subpart F Income Investment in US Property Gain from sale of CFC stock ( 1248) 9

10 US Taxation of Foreign Source Income Taxation through Distributions or Deemed Distribution Subpart F Income includes: 953 Insurance Company Income Foreign Personal Holding Company Income Foreign Base Company Sales Income Foreign Base Company Services Income Boycott Income, Bribes and Kickbacks Exceptions: Same Country Exceptions, Active Financing 956 Investment in US Property A CFC s pro rata share of investment in US Property Ex: Tangible Property, Debt obligations of related US Parties Gain from sale of CFC stock ( 1248) 10

11 US Taxation of Foreign Source Income What foreign income is NOT federally taxed in the US? Undistributed Earnings of Controlled Foreign Corporations Foreign Sourced Income of Foreign Corporations States may factor undistributed earnings of CFCs into worldwide apportionment formula 11

12 Foreign Commerce Clause and Jurisdiction Treaty provisions that limit the application of federal tax to foreign corporations that have a permanent establishment in the United States do not apply to the states (unless the states voluntarily apply them) 12

13 13 Foreign Commerce Clause and Jurisdiction Four requirements of Complete Auto Transit v. Brady, 430 U.S. 274 (1977): Substantial Nexus Fairly apportioned Not discriminate against interstate commerce Fairly related to services provided by the state Plus two additional requirements from Japan Lines, Ltd. v. County of Los Angeles, 441 U.S. 434 (1981): States cannot create a substantial risk of international multiple taxation States cannot prevent federal government from speaking with one voice with regard to international relations

14 Foreign Commerce Clause and Jurisdiction States have jurisdiction to impose on corporations meeting substantial nexus standards an apportioned income tax that does not discriminate against foreign commerce Employees or property in state generally creates nexus Economic nexus: Use of intangible (e.g., patent) in state Specified amount of sales to customers in state 14

15 Foreign Commerce Clause and Jurisdiction - example Connecticut Deemed to have nexus if greater than $500,000 in receipts attributable to Connecticut sources. Legislation limits the application to foreign companies. Specifically, economic nexus provisions do not apply to a foreign corporation that has no income effectively connected with a United States trade or business. To the extent that a foreign company has income effectively connected with a United States trade or business, such company's gross income shall be its income effectively connected with its United States trade or business. 15

16 Foreign Commerce Clause and Jurisdiction U.S. Company Goods Foreign Manufacturer Foreign manufacturer sells goods to a company headquartered in NY Goods shipped via common carrier to U.S. Company s distribution centers throughout the United States Foreign manufacturer has no physical presence or solicitation activities in the U.S. Foreign manufacturer has no effectively connected income Does Foreign Manufacturer have nexus with any state? 16

17 Foreign Commerce Clause and Jurisdiction Does P.L apply to foreign commerce? Most states appear to apply P.L to foreign corporations California says: No. Dresser Industries, Inc., SBE, 82-SBE-307, June 29, 1982, reh g denied, October 26, CA Reg (c) Issues may arise if: Foreign company uses company vehicles and personnel to deliver goods Particularly if they pick up returned/damaged goods Foreign company conducts non-solicitation activities in the state (even if through third parties), such as Training on use of products Repair services Investigating credit Repossessing goods Collecting accounts 17

18 Tax Base Most states use federal taxable income as the starting point for computing state taxable income. Federal taxable income takes into account the concepts of ECI and PE where a treaty applies Without a modification, foreign corporations with no federal taxable income reported on Form 1120F arguably have no state taxable income (but may have minimum tax obligations) Some states use ECI as a starting point, but don t respect treaty exemptions Without modification, income reported on Form 1120F is generally limited to income earned in the U.S., not worldwide income 18

19 Tax Base Some states explicitly require worldwide income computations without regard to limitations on taxable income under the IRC or treaties required. No longer required in New York and possibly New Jersey when reporting on a separate company basis. 19

20 Tax Base - Dividends Federal Treatment of Dividends IRC 243 Dividend received deduction (DRD) Only applies to dividends received by a corporation (a)(1) - 70% (general rule, any corporation)(30% taxed) (a)(2) 100% (small business) (0% taxed) (a)(3) 100% (qualifying dividends) (0% taxed) No DRD allowed for dividends received from foreign corporations 20

21 Tax Base - Dividends Kraft General Foods, Inc. v. Iowa, 505 U.S. 71 (1992) Iowa based its state income tax on federal taxable income as reported under the IRC computed on a separate return basis Under the IRC, dividends from a domestic corporation were eligible for 100% Dividend Received Deduction ( DRD ) in various percentages but dividends from foreign subsidiaries were not Kraft argued that Iowa violated the Commerce Clause by discriminating against foreign commerce because the DRD was allowed for dividends paid from domestic but not foreign subsidiaries Iowa argued that the Iowa system was justified because it followed the IRC and resulted in considerable administrative efficiency in administering the tax The Court reversed the Iowa Supreme Court and held that the Iowa tax facially discriminated against foreign commerce. Blind conformity was held to be unconstitutional. 21

22 Tax Base - Dividends Critical Importance of Factor Representation States like New Hampshire and Vermont that tax foreign dividends must provide factor representation to avoid constitutional issues. Dividends are separately apportioned to allow foreign factors that generated the income to dilute the domestic apportionment fraction. However, there are a number of practical problems that must be considered: Recognition of Tiered Structures--What if the entity that pays the dividend to the water s edge group is a holding company and therefore does not have the operational factors that produced the income? Recognition of Multiple Accounting Periods--What if the entity has negative taxable income in the year the dividend is paid, or the factors have declined substantially? 22

23 Tax Base Subpart F Under Subpart F, certain taxpayers are taxed directly on income earned by certain controlled foreign corporations States generally include Subpart F income in the state tax base unless a specific exemption applies 23 Some states provide a specific deduction for Subpart F income or include Subpart F income as a dividend eligible for a dividends received deduction; California water s-edge filers include a portion of CFC s income in water s edge return The CFC s net income is multiplied by a ratio of its subpart F income for the taxable year to its earnings and profits ( E&P ) for the taxable year to arrive at the amount of CFC income that will be included in the combined Report.

24 Tax Base Subpart F Generally, IRC 1248 provides that if a taxpayer owns 10% or more of the stock of a CFC and such stock is sold, then gain attributable to the sale is treated as a dividend from the foreign corporation to the extent of the stockholder s share of the corporation s E&P IRC 1248 has the effect of converting capital gain to dividend income potentially eligible for any state DRD Most states do not modify the treatment of gains from the sale of a foreign corporation s stock mandated by 1248 Some exceptions: California does not incorporate IRC Sec Cal. Rev. & Tax. Code Alaska DRD does not apply to gain treated as a dividend for federal tax purposes under Internal Revenue Code section Alaska Admin. Code tit (h). 24

25 Tax Base Section 78 Gross Up Generally, IRC 78 provides that if a taxpayer owns 10% or more of a foreign corporation and is claiming foreign tax credits, then any dividend from that foreign corporation is grossed up for the foreign taxes deemed paid by the corporation (See IRC 902 and 960) Because states do not allow the use of the foreign tax credits, most allow the 78 gross-up portion of the dividend to be subtracted from federal taxable income MA allows only 95% to be deducted from federal taxable income 25

26 Tax Base Expense Disallowance Some states may disallow expenses associated with Subpart F income or foreign dividends The subtraction for Subpart F income may be net of expenses North Carolina provides a subtraction for Any amount included in federal taxable income under section 78 or section 951 of the Code, net of related expenses. N.C. Gen. Stat (b)(3b). Other states have a more general disallowance provision No deduction shall be allowed for any amount otherwise allowable as a deduction which is allocable to one or more classes of income not included in the measure of the tax imposed by this part, regardless of whether that income was received or accrued during the taxable year. Cal. Rev. & Tax. Cd (a). 26

27 Tax Base Expense Disallowance California case concerning expense disallowance: In Apple Inc. v. Cal. Franchise Tax Board, 199 Cal App 4 th 1 (2011), petition for rev. den., 2012 Cal. LEXIS 324 (2012), the California Court of Appeals, affirming a superior court decision, held that a state corporate income/franchise taxpayer successfully showed that its loan interest expenses were allocable to its taxed domestic earnings, rather than to its non-taxed dividends received from foreign subsidiaries, as the dominant purpose of the underlying borrowings was to fund its domestic operations. 27

28 Tax Base Related-Party Expense Disallowance Generally, a requirement to add back otherwise deductible expenses that arise as a result of certain related-company transactions, unless an exception applies, such as if the related member is subject to tax in another state Example of a typical expense disallowance provision: For purposes of computing net income under this chapter, a taxpayer shall add back otherwise deductible interest expenses and costs and intangible expenses and costs directly or indirectly paid, accrued, or incurred to, or in connection directly or indirectly with one or more direct or indirect transactions with, one or more related members. Mass. Gen. L. Ch. 63, Sec. 31I(b) 28

29 Tax Base Related-Party Expense Disallowance Treaty Exception May be part of subject to tax in another state exception Some states merely require that payee be located in a treaty country Generally, a comprehensive income tax treaty is a convention or agreement, entered into by the U.S. and approved by Congress, with a foreign government for the allocation of all categories of income subject to taxation or the withholding of tax on interest, dividends, and royalties for the prevention of double taxation of the respective nations residents and the sharing of information. See, e.g., Ga. Code. Ann (a)(1). 29

30 Apportionment - Throwback Throwback If taxpayer is not taxable in destination country, sales may be thrown back to state or origin Under the MTC, [a] taxpayer is taxable in another State if (1) in that State he is subject to a net income tax, a franchise tax measured by net income, a franchise tax for the privilege of doing business, or a corporate stock tax, or (2) that State has jurisdiction to subject the taxpayer to a net income tax regardless of whether, in fact, the State does or does not do so. State is defined to include a foreign country 30 What is the appropriate standard to determine if a foreign country has jurisdiction to subject the taxpayer to a net income tax?

31 Apportionment - Throwback Should P.L be used to determine if a taxpayer is taxable in a destination jurisdiction outside the U.S.? California does not apply P.L to foreign commerce Thus, solicitation activity in a foreign country is sufficient to create nexus and prevent throwback However, this does not apply to sale to Puerto Rico (i.e., Puerto Rico is treated as a state ) New Hampshire, on the other hand, has attempted to force companies to show greater levels of activity to prevent throwback, ranging all the way to permanent establishment! 31

32 Filing Methods Worldwide combined reporting Held constitutional in Container and Barclays Bank, but no state currently requires worldwide combined reporting without providing water s-edge election except for Alaska Water s-edge reporting Election in several states e.g., California, Idaho, Utah, Massachusetts Required in many states e.g., Illinois, Wisconsin, Michigan, Minnesota Some states exclude all foreign corporations from their unitary returns filed on a water s edge basis; however, most states still include foreign corporations under certain circumstances 32

33 Filing Methods - Foreign Entity Inclusion Some typical rules for inclusion of foreign entities: A foreign corporation may be included in a unitary return if it is subject to federal income tax or required to file a federal income tax return A foreign corporation may also be included in a unitary return to the extent of its ECI A foreign corporation with no ECI may be included in a unitary return to the extent of its U.S. source FDAP income A foreign corporation may be included in a unitary return to the extent that 20% or more of its activity is within the US Some states will look at the average of the corporation s property and payroll factors Other states look at the average of the corporation s property, payroll, and sales factors Another approach is whether the corporation has less than 80% active foreign business income 33

34 Filing Methods - Foreign Entity Inclusion A CFC may be included in a unitary return to the extent of its subpart F income In CA, a CFC is included in the unitary return based on the ratio of its subpart F income to current year E&P In WV, the income of a CFC is included to the extent of its subpart F income, but any income that was subject to an effective rate of tax in a foreign country that is greater than 90% of the maximum federal rate is excluded (i.e., high tax CFC exception) In NH, Subpart F income is asserted to be taxed as foreign dividends and given foreign factor modification 34

35 Filing Methods - Foreign Entity Inclusion A new concept is the inclusion of a foreign corporation in a unitary return if it earns more than 20% of its income, directly or indirectly, from intangible property or service related activities, the costs of which are deductible against the business income of other members of the unitary group (DC, MA, and WV) Inclusion is limited to the extent of the income and apportionment factors related to such intangible property and service related activities In DC, the provision is limited to foreign corporations that are residents of a country that does not have a comprehensive income tax treaty with the U.S. In WV, the provision does not apply to income that is exempt from federal income tax pursuant to a comprehensive income tax treaty with the U.S. 35

36 Filing Methods - Foreign Entity Inclusion A small number of states are also including a foreign corporation in the unitary return if it is incorporated or doing business in a tax haven jurisdiction (e.g., AK, DC, MT, and WV) In AK, a tax haven jurisdiction is a country that does not impose an income tax, or that imposes an income tax at a rate lower than 90% of the US rate For the AK tax haven provision to apply, the foreign corporation must either: (1) have 50% or more of its sales, purchases, or payments of income or expenses, exclusive of payments for intangible property, made directly or indirectly to one or more members of the unitary return; or (2) not conduct any significant economic activity In DC, the definition of a tax haven means a jurisdiction that may have one of statutorily enumerated traits. REPEALED NOVEMBER 2015 In MT, the list of tax haven countries is set forth by statute and is updated as necessary 36 In WV, the list of tax haven countries is based on the OECD tax haven designations

37 Filing Methods - Foreign Entity Inclusion 37 Tax Haven - Developments Recent tax haven legislative activity: Colorado (Senate Committee postponed action on May 1, 2015) Maine (Governor vetoed in 2014, and 2015 renewal efforts failed) Massachusetts (House withdrew proposed legislation on April 27, 2015) New Hampshire (House tabled bill March 11, 2015) Oregon (enacted Or. Rev. Stat , effective for tax years beginning on or after January 1, 2014) Rhode Island (enacted R.I. Gen. Laws (c)(8), (d), effective for tax years beginning on or after January 1, 2015) Connecticut (effective in 2016 Legitimate Business Purpose Exception and Income Tax Treaty Exception Lux, Ireland, Switzerland) Discussions in AL, KY, LA, NJ, CO, PA, and VT

38 Tax Haven Summary of Problems Arbitrary and Misleading Unsuitable to Address Tax Avoidance Complaints Extends State tax jurisdiction beyond National tax jurisdiction per agreed Income Tax Treaties Inconsistent with Permanent Establishment concept Foreign Nations and MNCs will withhold investment and trade A Slippery Slope to Worldwide Unitary Can include companies that are not subject to U.S. National tax reporting Creates complex administrative difficulties Need to convert local books and currencies into formats acceptable to various U.S. States Uncertainties Is Ireland, The Netherlands, or even the UK, a Tax Haven? How many more States may adopt some form of Tax Haven rules? 38

39 Transfer Pricing I.R.C. 482 Federal transfer pricing authority generally involves international pricing. Are states required to respect federal determinations? States vary as to the statutory authority granted to adjust transfer prices Comptroller of the Treasury v. Gannett Co., 741 A.2d 1130 (Md. 1999) (state found not to have transfer pricing authority) New Jersey TAM (Feb. 16, 2012) [I]n most circumstances, APAs and their content, including pricing methodologies, economic assumptions and analysis and market valuations, will be respected by the Division. 39

40 Transfer Pricing MTC Transfer Pricing Program: the MTC has formed an Arm s- Length Adjustment Service Advisory Group ( ALAS ). Some key elements: Training of staff (a transfer pricing expert has been brought on board) Secure cost-effective economic analyses of transfer pricing studies Initially from third parties Eventually by MTC staff Provide initial technical audits prior to economic analyses 40

41 Federal Inversion Rules Regs Final Regulations issued October 13, 2016 Generally: certain related party debt instruments may be reclassified as stock unless certain rules are met Impact: revolving credit agreements may turn into equity Scaled back version of original draft: Rules do not apply to foreign-issued debt and some other instances Regulations are still a work in progress Reserved sections include non-us issued intercompany loans and obligations not in debt form, downward attribution rules Two new rules: Documentation Rules Per Se Stock / Transaction Rules 41

42 Federal Inversion Rules Regs Documentation Rules Introduces new documentation requirements to the debt/equity analysis of related party debt instruments. Applies to debt instruments issued by a US corporation to members of its Expanded Group, which is generally corporations affiliated by 80% common vote or value. Failure to meet rules will generally treat debt as stock for US federal income tax purposes Required Documentation for Debt Agreements: Legally binding obligation to pay a certain sum Creditor Rights Reasonable Expectation of Payment Proof of Debtor/Creditor Relationship Exemptions and Safe Harbors: Excepted Regulated Financial Companies and Regulated Insurance Companies Cash Pooling Agreements 42

43 Federal Inversion Rules Regs Per Se Stock / Transaction Rules Debt obligations will be treated as stock if issued by a US Corporation to a member of its Expanded Group and either: The debt instrument was issued in certain General Rule Transactions, or The US corporation engages in certain Funding Rule Transactions during the 3- years before or after the debt issuance General Rule Transactions: issuance of a note by a US Corp: And distributes its own note to a non-us parent In exchange for stock of a non-us parent In certain asset reorganizations where the instrument is received as boot Funding Rule Transactions: if the US Corp debt issuer: Makes a distribution of cash or property to its non-us parent Acquires stock from its Expanded Group Distributes the debt instrument to an Expanded Group member as boot in an asset reorganization Exceptions: Qualified Short-Term Debt Instruments 43

44 Federal Inversion Rules Regs What should your company do next about new 385 Regs? Identify Debt Instruments that could be subject to the Documentation and Per Se Stock Rules Review existing agreements for compliance with the Regulations Develop procedures to ensure future debt instruments will comply with Regulations 44

45 OECD BEPS Framework Organization for Economic Cooperation and Development = OECD Base Erosion Profit Shifting = BEPS The BEPS Framework is aimed at tax planning strategies that exploit gaps and mismatches in tax rules to artificially shift profits to low or no-tax locations where there is little or no economic activity. Requirements are being passed at individual country level per recommendation of OECD 45

46 OECD BEPS Action Items Action 1: Digital Economy Action 2: Hybrid Mismatch Arrangements Action 3: Controlled Foreign Company Rules Action 4: Interest Deductions Action 5: Harmful Tax Practices Action 6: Preventing Treaty Abuse Action 7: PE Rules Action 8 10: Transfer Pricing Action 11: Measuring and Monitoring BEPS Action 12: Mandatory Disclosure Rules Action 13: Transfer Pricing Documentation and Country-By- Country Reporting Action 14: Solving Treaty Disputes 46 Action 15: Bilateral Treaty Instrument

47 OECD BEPS Action Items Action 7: PE Rules Prevent avoidance of PE via Commissionaire arrangements Re-think the Preparatory or Auxillary exception for PE Determination Action 13: Transfer Pricing Documentation and Country-By-Country Reporting 3-tier approach to Global Transfer Pricing Reporting Master File Local File Country-by-Country Reporting or CbCR 47

48 OECD BEPS Action 13 Items Master File High level information regarding the company s global business operations and transfer pricing policies Local File Specific to each country, identifying material related party transactions, amounts involved in those transactions, and the company s analysis of the transfer pricing determinations they have made with regard to those transactions CbCR For each tax jurisdiction a MNE does business, provide a report of the amount of revenue, profit before income tax, and income tax paid and accrued, number of employees, stated capital, retained earnings, and tangible assets in each jurisdiction. Identify each entity within the group doing business in a particular tax jurisdiction and to provide an indication of the business 48 activities each entity engages in.

49 Conclusion Taxation of Foreign Source Income will continue to be an issue of growing importance. International Reach of Corporations Due to Open Markets and Technology Need for revenue and perception of tax avoidance States are increasingly aggressive but states have widely disparate statutes that offer pitfalls and opportunities. To the extent that federal tax reform becomes a reality, careful planning must be done regarding repatriation of earnings. 49