International Tax Primer Andrew D. Oppenheimer, Esq. October 31, 2017
Agenda International tax concepts Taxation of foreign earnings Sourcing of income and expenses Foreign tax credits Subpart F income Transfer pricing Recent developments Reform proposals
International tax concepts
International tax concepts Worldwide An approach to taxation used by countries like the US, that taxes its citizens, resident aliens and domestic corporations on their worldwide income This approach creates risk of double taxation on the same item of income (i.e., by country of residence and by country of source) In the US, this double taxation can be mitigated in the following ways: Foreign tax credit ( FTC ) with respect to certain foreign taxes, which is elective Deduction for foreign taxes paid Tax treaties Nonresidents and foreign corporations are generally subject to tax by a country using worldwide taxation only on income from sources in that country Territorial An alternative approach that taxes only income earned in that country
International tax concepts Taxation of US and non-us persons US persons: US taxes worldwide income of US persons To prevent double taxation of foreign source income, may annually elect to claim a credit for foreign income taxes If no election, foreign taxes are deducted Credit is limited to portion of taxpayer s pre-credit US tax attributable to foreign source income Non-US persons: US uses a two-pronged system to tax US source income of foreign persons US source investment-type income is subject to gross basis withholding tax (30% subject to reduction by treaty) Net amount of income effectively connected with a US trade or business is subject to tax at the regular graduated rates
International tax concepts Taxation of US-owned foreign corporations Deferral Foreign subsidiary is not includible in US consolidated return US generally does NOT tax a foreign subsidiary s undistributed foreign source income Result Defer residual US tax until sub pays a dividend Policy Help US companies compete outside the US Anti-deferral Deny deferral to tainted foreign earnings Simultaneously allow deferral for active foreign business profits Specific regimes Subpart F (enacted in 1962) PFIC (enacted in 1986)
International tax concepts What is a PFIC and why do we care? Passive Foreign Investment Company ( PFIC ) - 1297(a) A foreign corporation is categorized as a PFIC if either: 75% or more of its gross income is from passive income, or 50% or more of the value of its assets either produce or are held for the production of passive income. Adverse tax treatment Generally, US shareholders of PFICs are subject to tax and interest charges on any excess distributions from a PFIC, including any gain on the disposition of PFIC stock (unless an election is made to include the income annually). An investor could be exposed to potentially severe tax liabilities by not identifying the PFIC status of the foreign equities held in a portfolio.
International tax concepts What is a CFC and why do we care? Controlled Foreign Corporations ( CFCs ) - 957(a) Any foreign corporation if more than 50% of 1) the total combined voting power of all classes of stock of such corporation entitled to vote, OR 2) the total value of the stock of such corporation, is owned (within the meaning of 958(a)), or is considered as owned by applying the rules of ownership of 958(b), by US shareholders on any day during the taxable year US Shareholder A US person who owns, or is considered as owning by applying the constructive ownership rules of 958(b), 10% or more of the total combined voting power of all classes of stock entitled to vote of such foreign corporation This US person could be subject to deemed income inclusions under Subpart F with respect to a CFC (Subpart F is an exception to deferral)
International tax concepts E&P and tax pools: Important tax attributes used in FTC planning Earnings and profits ( E&P ) A measure of the income/dividend capacity of a foreign corporation Based upon domestic concepts It could be a deficit Book earnings of the foreign corporation plus/minus adjustments Tracked separately for each foreign corporation Maintained in the foreign corporation s functional currency Tax pools A measure of the potentially creditable foreign taxes paid by the foreign corporation attributable to its E&P
International tax concepts USP USS Foreign Holdco Foreign Holdco Foreign Holdco Foreign Holdco Foreign Opco Foreign Holdco Foreign Opco Foreign Opco Foreign Opco
International tax concepts Importance of a foreign corporation s E&P to US shareholders CFCs Subpart F income is limited to current E&P, and reduced by a qualified deficit in E&P Section 956 inclusion is limited to applicable earnings Gain on sale of CFC stock is dividend to extent of E&P Annual reporting of current and accumulated E&P PFIC E&P is used to determine annual inclusion (if elected) Foreign corporations in general E&P is used to determine if a distribution is a dividend E&P is used to compute deemed paid FTCs E&P is used in applying look-through rules for basketing dividends Deemed dividend from inbound subsidiary liquidation or inbound reorganization is based on all E&P amount Interest expense apportionment Basis in stock of CFC is increased by E&P
International tax concepts: Sourcing
Sourcing of income and expenses Why is sourcing important? Income sourcing and expense allocation are important for purposes of determining a taxpayer s ability to use FTCs Note: does not change total taxable income of US person Sourcing rules determine taxable income of foreign persons Total taxable income US source income Foreign source income
Sourcing of income and expenses Overview of sourcing process Goal: determine geographic origin of income Gross income Step 1: determine statutory category (interest, rents, dividends, etc.) Step 2: apply category-specific source rule Deductions Step 1: allocate to related class of gross income Step 2: apportion between US and foreign source income based on factual relationship of deductions to gross income
Sourcing of income and expenses General income sourcing rules Interest sourced to residence/place of incorporation of payor Dividends sourced to place of incorporation of payor Rents/Royalties sourced to location of property/permitted place of use Personal Services generally place of performance Sale of Real Property sourced to location of property Sale of Personal Property generally sourced to location of property Inventory sourced to place of sale where title passes to buyer, generally. Also consider special rules (section 863(b) sales 50/50)
Sourcing of income and expenses Expense apportionment rules Regulations under 861 Interest expense (special rules due to fungibility) R&D expenditures State income taxes Net operating losses Stewardship expenses Losses from sale of property Legal and accounting expenses Charitable contributions
International tax concepts: Foreign tax credit regime
Foreign tax credit regime Credit vs. deduction of certain foreign taxes General rules Foreign taxes are deductible business expenditures Foreign tax credit regime is elective FTC is generally preferable to a deduction FTC reduces US income tax liability dollar-for-dollar A deduction, however, may be preferable in an NOL context Consider the FTC limitation ( 904) It limits the FTC to the US tax on foreign source taxable income How might you maximize the FTC? Maximize foreign source income and minimize foreign source deductions Remember that not all E&P and related tax pools are the same
Foreign tax credit regime Types of FTC Direct credit Available under 901 (and 903) A credit for taxes imposed on and paid by the US taxpayer (e.g., withholding tax or foreign taxes paid by the US for operations in a foreign branch) Indirect (deemed paid) credit Available under 902 To US corporate shareholders who directly own 10% of voting stock For taxes imposed on a foreign subsidiaries within the Qualified Group Available under 960 To US corporate shareholders that have an income inclusion under 951(a)(1) (i.e., subpart F income or a 956 inclusion from a CFC)
Foreign tax credit regime Types of FTC (cont.) Section 901 Taxes paid on income of foreign branch or partnership Section 903 Taxes withheld by foreign payers of dividends, interest or royalties Sections 902 and 960 Taxes of foreign subs that are deemed paid upon receipt of dividend USP USP USP Foreign branch Income Foreign payers Dividend Interest Royalties Foreign subsidiary Dividends Subpart F inclusions
Foreign tax credit regime Example of section 901 direct FTC US corporation Foreign branch Foreign Net Income (before reduction for taxes) $1,000 Foreign Tax Paid $250 If US corporation earns income from foreign operations through a branch, US corporation is treated as paying the foreign tax directly and may, subject to the FTC limitation rules, receive a direct FTC (i.e., a 901 credit) US Corporation includes $1,000 in its income and claims a FTC of $250
Foreign tax credit regime Section 901 example: Credit vs. other methods compared Example: USCo operates a foreign branch that has $100 of foreign earnings. Foreign tax rate is 20%, US rate is 35% Methods of mitigating double taxation Foreign tax + US tax = Effective tax rate None $20 $35 55% Deduction for foreign tax $20 $28 48% Credit for foreign tax $20 $15 35% Exemption for foreign income $20 $0 20%
Foreign tax credit regime Section 902/960 indirect (deemed paid) FTC 1 st tier subsidiaries Also known as the deemed paid credit The US corporation is deemed to have paid, for purposes of 901, certain foreign taxes paid by foreign corporations if it satisfies the 10% direct ownership threshold Available when foreign subsidiary makes actual or deemed cash and non-cash dividends (i.e., distributions treated as dividends under 301(c)(1)) Available when there is an income inclusion under either the subpart F rules or as a 956 inclusion from a CFC
Foreign tax credit regime Section 902/960 indirect (deemed paid) FTC - Lower tier subsidiaries US corporation CFC Dividend Dividend Qualification requirements Minimum 10% direct ownership at each level Minimum 5% indirect ownership through chain Dividend distributions up to US parent Number of qualifying tiers Can look down to the 6th tier (but only if CFCs) What if the taxes reside below the 6th tier? Tracing foreign taxes to dividends CFC
Foreign tax credit regime Section 902/960 indirect (deemed paid) FTC - Example US corporation CFC Foreign Income $100 Foreign Tax $30 Foreign E&P $70 $70 Dividend If US corporation receives a distribution from CFC who earned the income and paid foreign tax, US corporation has not directly paid any foreign taxes and thus cannot receive a 901 credit However, under 902, US corporation will treat the $30 of taxes paid by CFC as deemed paid by US corporation and thus creditable US corporation will include $100 in gross income ($70 dividend plus $30 78 gross-up) and may be able to claim a FTC of $30 against US tax due of $35 ($100 x 35%)
Foreign tax credit regime Foreign tax credit limitation - Section 904 Purpose Limit credit to US tax on foreign-source income Credit is not intended to offset US tax on US-source income Foreign tax credit limitation Pre-credit = US tax x Foreign-source taxable income Total taxable income How to increase limitation? Gross income Deductions Maximize foreign-source income for US tax purposes (e.g., 863(b) sales) Maximize US-source deductions for US tax purposes (e.g., 861 allocation)
Foreign tax credit regime Separate basket foreign tax credit limitations Section 904(d) General rule Separate limitations applied to: Passive category income General category income How separate basket limitations work Allocate total foreign source income and total foreign taxes between two baskets Compute separate limitation and separate credit for each basket Total credit = sum of credits from each basket US source income Total taxable income General category income Foreign source income Passive category income
International tax concepts: Subpart F
Subpart F income The problem with portable income Perceived abuse: Deferral provides a tax incentive to channel investment income, inventory trading profits, and other portable income through a foreign corporation based in a low-tax foreign jurisdiction Income earned abroad subject to lower tax rates that could have been earned in the US Without Subpart F, no US tax on income until repatriated by a CFC due to the general rule of deferral
Subpart F income Example of perceived abuse Assume: German CFC manufactures goods for sale by US corporation in the US market. Cayman CFC has no substance (no employees, no office, etc.) Sells goods @ 20 per unit US corporation Sells goods @ 20 per unit CFC (Germany) Sells goods @ 10 per unit CFC (Cayman) Manufactures goods COGS: 10 per unit
Subpart F income Overview To target the perceived abuse, certain categories of income ( tainted income ) became subject to immediate inclusion in the US Shareholder s taxable income Tainted income Subpart F income (foreign base company and insurance income) Investments in US property Subpart F inclusion Immediate inclusion whether or not actual dividend received by US Shareholder of CFC FTC available Subsequent distributions treated as previously taxed income (so-called PTI)
International tax concepts: Transfer pricing
Transfer pricing In general Definition: Pricing of transactions between controlled entities Perceived abuse: Due to the special relationship between related parties, the transfer price may be different than the price that would have been agreed between unrelated parties
Transfer pricing Example of perceived abuse Assume: German CFC manufactures goods for sale by US corporation in the US market. Cayman CFC has no substance (no employees, no office, etc.) Sells goods @ 20 per unit US corporation Sells goods @ 20 per unit CFC (Germany) Sells goods @ 10 per unit CFC (Cayman) Manufactures goods COGS: 10 per unit
Transfer pricing Rules and regulations Section 482 Goal Gives IRS authority to make allocations necessary to prevent evasion of taxes or clearly to reflect the income of organizations, trades or businesses It also provides that in respect of intangible property transactions, the income with respect to such transfer or license shall be commensurate with the income attributable to the intangible Ensure that pricing of transactions between controlled entities is consistent with the pricing of transactions between third parties (the so-called arm s length standard)
Transfer pricing Potential penalties Objective Encourage taxpayers to make reasonable efforts to determine and document the arm s-length character of their inter-company transfer prices Unless a taxpayer can demonstrate reasonable cause and good faith in determination of the reported transfer price, 20% non-deductible transactional penalty on a tax underpayment attributable to a transfer price claimed on a tax return that is 200% or more, or 50% or less than the arm s-length price, or 40% if the reported transfer price is 400% or more, or 25% or less than the arm slength price. Contemporaneous documentation To avoid a transfer pricing penalty, a taxpayer must maintain sufficient documentation to establish that it reasonably concluded that, given the available data, its selection and application of a pricing method provided the most reliable measure of an arm s length result and must provide that documentation to the IRS within 30 days of a request for it in connection with an examination of the taxable year to which the documentation relates.
Recent developments
Recent developments Regulations Temp. Treas. Reg. 1.482-1T(f)(2), T.D. 9738 (aggregate valuation in transfer pricing) Treas. Reg. 1.6038-4, T.D. 9773 (country-by-country reporting) Treas. Reg. 1.987-0 through 1.987-11, T.D. 9794 (gain or loss on functional currency) Treas. Reg. 1.367(a)-0, 1.367(a)-1 through -7, 1.367(d)-1, 1.6038(b)-1, T.D. 9803 (final 367 regulations) Treas. Reg. 1.721(c)-1T through -7T, 1.6038B-2T, T.D. 9814 (transfer of built-in gain property to partnership) Treas. Reg. 1.385-1 through -4, T.D. 9790 (final section 385 regulations)
Recent developments Debt push down Inversion example (double dummy structure) Public Cash and stock Cash and stock Cash Stock and note New foreign parent Stock and note Cash and stock Cash and stock S/Hs US parent Merger US merger sub Foreign merger sub Merger Foreign parent Public S/Hs New foreign parent Creditor Debtor US parent Foreign parent
Recent developments Repatriation strategies All cash Ds How should we repatriate FS1 s 100x of earnings? USP AB: 100x AB: 10x FMV: 100x FS2 FS1 FMV: 100x E&P: 0x Taxes: 0x Tax rate: 10% E&P: 100x Taxes: 30x
Recent developments Repatriation strategies All cash Ds (cont.) USP transfers its shares of FS2 to FS1 in exchange for 100x cash/note and immediately after, FS2 files an election to be treated as disregarded from its owner from its owner, FS1. USP 100x cash/note 1 FS2 stock FS2 FS1 FS2 2
Recent developments Cases Grecian Magnesite Mining, Industrial & Shipping Co., SA v. Commissioner Decision July 13, 2017. Decision Tax Court rejected the IRS s longstanding position in Rev. Rul. 91-32 and held that the gain on the disposition of a US partnership interest by a foreign partner was US-tax-exempt. State aid (EU): Amazon: Final decision published in October 2017. Decision The EC found that Luxembourg approved non-arm s length royalty payments to be paid to Luxembourg entities. GDF Suez: Opening decision published in January 2017. Decision The preliminary decision by the EC is that Luxembourg misapplied the law. Apple: Final decision published in December 2016. Decision The EC found that the rulings given to the Irish subsidiaries endorsed an inappropriate attribution of profit within the Irish subsidiaries and constituted illegal state aid. 13 billion (plus compound interest). Sale of Novo Banco with additional aid in the context of the 2014 Resolution of Banco EspíritoSanto S.A.: Decision published in October 2017. Decision The EC has approved Portuguese aid for the sale of Novo Banco.
Recent developments BEPS Action Plan (2013) Objective: aligning transfer pricing outcomes with value creation Important: adherence to arm s length principle explicitly affirmed (didn t have to be that way could have taken formulary apportionment road). Respect for separate legal entities (including decisions to capitalize subsidiaries) Respect for allocations of risk (subject to accurate delineation of transaction analysis): Risk/return trade-off Risks do not have to align with functions (e.g., contract R&D) Need to fully remunerate contributions to value BEPS guidance is not always clear and is subject to different interpretations; BUT, adherence to ALP provides a key discipline/check on its interpretation.
Reform proposals
Reform proposals House proposals expected to be released November 1 The current US worldwide tax system will be replaced with a 100-percent exemption for dividends from foreign subsidiaries (in which the US parent owns at least a 10-percent stake). As part of a transition to this new dividend exemption system, the proposal treats foreign earnings that have accumulated under the old system as repatriated. Accumulated foreign earnings held in illiquid assets will be subject to a lower rate than foreign earnings held in cash or cash equivalents. Payment of the tax liability will be spread out over several years. The proposal states that additional international rules will be provided to stop corporations from shipping jobs and capital overseas. To prevent companies from shifting profits to tax havens, tax rules will be provided to protect the US tax base by taxing at a reduced rate and on a global basis the foreign profits of US multinational corporations. The tax committees also will incorporate rules to level the playing field between US-headquartered parent companies and foreign-headquartered companies.
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