US TAXATION SYSTEM Omri Yaniv International Tax Manager, PwC
US Taxation System - List of Topic Basis of taxation Taxation of foreign corporations US domestic law US tax treaties Types of U.S. entities Check the box regulations Foreign tax credit US Anti-deferral Provisions: Subpart F Rules; Passive Foreign Investment Corporation (PFIC) Rules Transfer Pricing 2
US Taxation System - General The US taxation system is primarily a personal based taxation system. US tax residents are taxed on their worldwide income Determination of residency (under domestic law) Corporation - a corporation is considered a US resident if incorporated in the United States Individual an individual is considered a US resident if he/she is either a US citizen or meets the (i) permanent residency status test; or (ii) the substantial presence test 3
Taxation of Foreign Corporations US Domestic Law The United States generally asserts only a limited taxing jurisdiction over foreign residents (e.g., foreign corporations). "Foreign corporation" a corporation incorporated under the laws of a country other than the United States. A foreign corporation pays US tax only on income that has sufficient nexus with the United States. In order to examine whether there is sufficient nexus, three variables need to be examined: The nature and source of the foreign corporation's income, i.e., whether derived from sources within the US or whether from sources without the US; The nature of the foreign corporation's activities, i.e., whether engaged in a "US trade or business"; and The relation between the income derived and the US activities, i.e., whether the income is "effectively connected" with a "US trade or business" 4
Taxation of Foreign Corporations US Domestic Law Variable I nature and source of the income Source Rules rules for determining the source of income for US tax purposes. In determining the source of an item of income the specific sourcing rule that governs that certain type of income must be identified, e.g.: Royalties - sourced in the place of use of the property for which the royalties are paid Rental Income - sourced at the location or the place of use of the leased property for which the rental income is paid Gains from the sale of personal property generally sourced by reference to the seller s country of residence (several exceptions exist) 5
Taxation of Foreign Corporations US Domestic Law Variables II & III nature of US activities and the relation between the income and the activities Whether the foreign corporation is engaged in a US trade or business: No definition of the phrase in the Internal Revenue Code (case-by-case resolution based the facts and circumstances). Fundamental distinction regular commercial activity versus passive investment. If the answer is positive, what portion of the income is effectively connected with the conduct of such US trade or business: The mere existence of a US trade or business is not sufficient to subject the investment income to the normal tax rates. The existence of a trade or business in the US does not affect the taxation of unrelated investment income 6
Taxation of Foreign Corporations US Domestic Law Income effectively connected with a US trade or Business If the foreign corporation (i) conducts a US trade or Business, and (ii) The income derived is effectively connected with such trade or business, then the income will be taxable in the United States on a net basis. Income not from a US Trade or Business If the foreign corporation (i) does not conduct a US trade or Business, or (ii) does conduct a US trade or business but the examined income is not effectively connected with such trade or business, then the income will be taxable in the US only if considered to be sourced within the US. 7
Taxation of Foreign Corporations US Domestic Law The operative US taxation result is dependant upon the source determination: Income Effectively Connected with a US Trade or Business: Subject to the provisions of any applicable treaty, a foreign corporation generally pays US income tax at the regular US rates on net income. Income not from a US Trade or Business: A foreign corporation is generally subject to US tax at a flat rate of 30% with respect to US-source gross income, subject to the provisions of an applicable tax treaty which may reduce tax imposed by the United States. Such tax is usually collected by way of withholding by the US-based payer, on amounts received from sources within the US by a foreign corporation. 8
Taxation of Foreign Corporations US Domestic Law Source Determination - Examples category of income If income is If income is not effectively connected effectively connected 1. Capital gains Net income taxed at No US tax regular corporate rate 2. Fixed or determinable Net income taxed at Gross income taxed at income (e.g., interest, regular corporate rate flat 30% rate dividend, royalties) 3. US real property Net income taxed at treated as effectively interest gains regular corporate rate connected income 4. Other income Net income taxed at treated as effectively regular corporate rate connected income 9
Taxation of Foreign Corporations Income Tax Treaties Treatment of Business Income - General In general, the US does not tax business income of a corporation that is resident in the country of a treaty partner unless the business income is attributable to a Permanent Establishment ( PE ) of the foreign corporation located within the United States. It is possible for a foreign corporation to be engaged in a US trade or business but not to be operating through a PE in the United States. 10
Taxation of Foreign Corporations Income Tax Treaties Treatment of Business Income - Definition of the term PE Any fixed place of business through which a resident of one of the Contracting States engages in industrial or commercial activity three conditions: The existence of a place of business Facility or other premises or, in certain instances machinery or equipment The place of business does not necessarily have to be owned or leased. Examples Office, branch, factory, place of management The place of business must be fixed Fixed place - link between the place of business and a specific geographical point. Fixed period of time not for a temporary period (permanency). Established at a distinct place with a certain degree of permanence. The business is carried on is conducted through the fixed place of business the enterprise must carry on its business (wholly or partly) through the premises. A PE may exist even if carried through automatic equipment (e.g., vending machine) 11
Taxation of Foreign Corporations Income Tax Treaties Treatment of Business Income - Definition of the term PE Status of a person acting on behalf of a non-us resident corporation in the US: A person with the authority to conclude contracts in the name of the non- US resident corporation within the US shall be deemed to constitute a PE in the US, unless: Such person is an independent agent of such non-us corporation; The relevant contracts relate to such matters that even if concluded through a fixed place of business would not make the fixed place of business a PE under the treaty (e.g., purchasing of goods). The activity of a non-us resident corporation in the US which is conducted through a broker, general commission agent or any other agent of independent status in the ordinary course of their business will not constitute a PE in the United States. The independence has to be from both a legal and an economical perspective. Strict supervision on the agent's activity and guidance are indication of a dependant status. Bearing of economical risks by the agent is indication of an independent status. 12
Taxation of Foreign Corporations Income Tax Treaties Treatment of Other Income Treaties which the US is a party to may: modify the US domestic source rules; Modify the taxation rules by providing for reciprocal reduction of rates for investment type income; or Exempt certain types of income. Examples from US/Israel treaty: Dividend reduction of withholding tax rate to 12.5% in case of a 10% or more corporate shareholder (from 30%) Interest reduction of withholding tax rate to 17.5% (from 30%); 10% in the case of financial institutions Royalties reduction of withholding tax rate to 10%/15% (from 30%) 13
Types of entities for U.S. tax purposes There are various types of entities for U.S. federal tax purposes, under two main categories: Separate entities for tax purposes: C-Corporation; Flow-Through Entities: Partnership (general or limited- LP); S- Corporation; Limited Liability Company (LLC); The law poses different requirements with respect to each type of entity (e.g., Restriction on type or number of members/ shareholders). 14
Types of entities for U.S. tax purposes Flow through entities are not taxed identically. Close analysis is required before deciding which entity to use for a specific activity. The tax treatment of the different flow through entities differs in many respects, such as: Limitation on losses deductible by owners; Highest tax rate; Basis for allocating income to owners; Non-liquidating distributions to owners; Reporting requirements and tax computations. Tax treatment of change in entity status (e.g., S election). 15
Types of entities for U.S. tax purposes Basic details in regard to the taxation of different types of U.S. entities: Partnership and LLC not subject to tax. Owners in their separate capacity subject to tax on their distributive share of income. Partnership must have at least two owners (LLC in some states may be owned by single member). S-Corporation Not subject to Federal income tax (except for certain built-in gains and passive income when present from C-Corporation tax years); C-Corporation Income subject to two-tier Taxation (corporate and shareholder level). 16
השואהבסיסיתביןסוגיההתאגדות שותפות LLP (בלתימוגבלת) LLC S-Corp C-Corp מס'בעלים כלמספר עד 2 ומעלה 75 ) עד שנת 97 עד 35) כלמספר ) ישדיןיחודילבעלים יחיד) ) מעטמדינותדורשותלפחות (2 סוגהבעלים איןהגבלות ישהגבלות איןהגבלות איןהגבלות איןהגבלות - יחידיםבלבד ) טרפ לחריגים) - תושביארה" בבלבד מיסויפדרלינפרד ברמתהגוף כן בעיקרון- אל לא לא בחירה. ברירתמחדל -לא ) חריגיםבולטים: /built in gains העברתנכסים 17
השואהבסיסיתביןסוגיההתאגדות אחריותמוגבלת מעמדלענין אמנהישראל- ארה"ב (כפוף LOB )ל- יש תושבארה"ב S-Corp יש עונהעל הגדרתחברה שלארה"ב תושבארה"ב יש דע( 97 הותנה בתנאיםרבים) לאברור ) קיםחוזר מ"ה) שותפות (בלתימוגבלת) אין רקבזיקהלהכנסות שהפיקהשותפות, אשרחיבתבמסשל מדינהכהכנסתתושב באותהמדינה, םא בידיהגוףהמתאים אובידישותפיו. לשותפים - אין הכללים.למעט העדראחריות לרשלנותמקצועית שלאחר. לשותפים המוגבלים. יש LLP רקבזיקהלהכנסות שהפיקהשותפות, אשרחיבתבמסשל מדינהכהכנסתתושב באותהמדינה, םא בידיהגוףהמתאים אובידישותפיו. LLC C-Corp 18
Check the box regulations Federal regulations ( 301.7701 1 to 4) Regulations that deal with the classification of legal entities for U.S. federal tax purposes; Regulations allow the classification of an entity by election in most cases; Basically divides all entities into eligible and ineligible classes. Entities ineligible for election Per Se Corporations (8 Categories) A business entity that is taxable as a corporation under another provision of the Internal Revenue Code (e.g., C-Corp); A business entity organized under a Federal or State statute, if the statute describes or refers to the entity as incorporated or as a corporation; Insurance Companies (Under subchapter L); Certain foreign entities (e.g., an Israeli Public Limited Company); More 19
Check the box regulations Eligible Entities A business entity that is not an ineligible entity. Main implication of eligible entities May elect federal tax classification: An eligible entity with at least two members can elect to be either a corporation or a partnership; An eligible entity with a single owner can elect to be classified as an association or to be disregarded as an entity separate from its owner (Branch). Limitation on election If an eligible entity makes an election, the entity cannot change its classification by election again during the sixty months succeeding the effective date of the election. An election by a newly formed eligible entity that is effective on the date of formation is not considered a change in regard to the above limitation. 20
Check the box regulations Classification of eligible entities that do not file an election (The default classification): Domestic eligible entity: If it has two or more members =>A partnership. If it has a single owner =>Disregarded as an entity separate from its owner. Foreign eligible entity: If it has two or more members and at least one member does not have limited liability =>A partnership. If all members have limited liability =>An association. If it has a single owner that does not have limited liability =>Disregarded as an entity separate from its owner. 21
Foreign Tax Credits (FTC) - General As mentioned above, US corporations are subject to US tax on their worldwide income. To alleviate the double taxation that may result when income of a foreign subsidiary that is earned in a foreign country is taxed both by the United States and the foreign country, US taxpayers are allowed a credit for foreign taxes paid on such income. Under US tax law, US corporations are entitled to two types of credits A direct foreign tax credit with respect to taxes imposed directly on the taxpayer (e.g., withholding tax on dividends, royalties and technical service fees) A deemed paid foreign tax credit with respect to taxes paid or accrued on the income of the foreign subsidiary ("indirect credit") The indirect credit is extended to taxes paid by up to the 6 th tier subsidiaries. 10% voting requirement at each tier level and with respect to subsidiaries below the 1 st tier, indirect ownership by the US parent of at least 5%. 22
Foreign Tax Credits (FTC) - Limitations Purpose of the limitation prevent the crediting of foreign taxes against US tax on income from US sources. Overall limitation Total amount of credit is limited to the total amount of US taxes that would have been paid on the foreign-source income: FTC Limitation = foreign source income x US tax worldwide income The Overall method allows the averaging of foreign rates. Basket Method in order to minimize the averaging effect: The worldwide income is allocated to eight separately defined baskets of income with the balance falling into a residual category, the "general limitation income basket". For each basket a separate overall foreign tax limitation must be computed. No cross-crediting - An excess foreign tax credit in one basket of income can not offset US tax on income (shortfall) in another basket. Excess FTCs can be carried back (two years) and carried forward (five years). 23
Foreign Tax Credits (FTC) Rules - Example Assumptions A US corporation has a Branch in country X that imposes tax at the rate of 45% on income derived from a business. The US corporation has excess funds deposited in an interest bearing account. Data: Branch profits USD 100. Interest income USD 100. Tax rates Country X 45%, US tax rate 35%, Bermuda 0%. Alternative I the deposit is in the US; Alternative II the deposit is in Bermuda. 24
Foreign Tax Credits (FTC) Rules - Example FTC computation without Baskets I II Foreign-source income [A] 100 200 US tax before FTC [B] (35) (70) Foreign taxes paid [C] (45) (45) Creditable amount [D=Min (B,C)] (35) (45) US tax liability after FTC [E=B-D] 0 25 Net profit [F=A-(C+E)] 55 130 US-source income [G] 100 -,- US tax liability [H] (35) -,- Net Profit [I=G-H] 65 -,- Total tax [J=C+E+I] (80) (70) Total net profit [K=F+I] 120 130 25
Foreign Tax Credits (FTC) Rules - Example FTC computation with Baskets Active Basket Passive Basket Total Foreign-source income [A] 100 100 200 US tax before FTC [B] (35) (35) (70) Foreign taxes paid [C] (45) ( 0) (45) Creditable amount [D=Min (B,C)] (35) ( 0) (35) US tax liability after FTC [E=B-D] 0 35 35 Net profit [F=A-(C+E)] 55 65 120 US-source income [G] -,- -,- -,- US tax liability [H] (-,-) -,- -,- Net Profit [I=G-H] -,- -,- -,- Total tax [J=C+E+I] (45) + (35) = (80) Total net profit [K=F+I] 55 + 65 = 120 26
US Anti-Deferral Rules - General Tax planning under personal based taxation systems, such as in the US, focuses on deferral rather than on avoidance of taxation. Such planning usually involves the creation of a foreign subsidiary, in a country that imposes little or no tax, which is intended to carry out the activities with respect to which the deferral is sought. The deferral is achieved due to the fact that the income of a foreign corporation is not taxed to the shareholder until repatriated. Tax deferral is of interest only if the foreign country's rates are lower than those of the US. The US has enacted several Anti-deferral regimes main sets of rules: Subpart F rules aimed at income generated by controlled foreign corporations (CFC); Earnings invested in US property; and Passive Foreign Investment Company (PFIC) rules aimed at income generated by foreign corporations that are partially owned, but not controlled, by US residents. 27
US Anti-Deferral Rules Subpart F Rules Definition of a CFC: A foreign corporation; More than 50% of either the voting stock or the total value of all stock is owned by US shareholders. "US shareholder" - US persons owning directly or by attribution 10% or more of the voting stock of the CFC 28
US Anti-Deferral Rules Subpart F Rules Subpart F income two principal categories of "foreign base company income" (FBCI): Income from dealings with related parties which were channeled through the "base" company : foreign base company sales income income from property purchased from or sold to a related person if the property is manufactured outside and sold for use outside the CFC's country of incorporation.; Foreign base company service income income derived from performing services outside the CFC's country of incorporation for or on behalf of a related person. Passive investment income. FBCI does not include income that was subject to an effective tax rate in a foreign country that was greater than 90% of the maximum marginal US corporate tax rate (90%*35%=31.5%) 29
US Anti-Deferral Rules Subpart F Rules Tax treatment of a US shareholder: A US shareholder is taxed on its pro-rata share of the CFC's undistributed subpart F income, or the undistributed earnings invested in US property. A foreign tax credit is granted to the US corporate shareholder for the taxes it is deemed to have paid on such income. When such income is subsequently actually distributed as dividend, no further tax is imposed in the US. The basis of the US shareholders in the CFC is increased by the amount of any subpart F income taxed in the US and decreased by subsequent distribution of previously taxes subpart F income. 30
US Anti-Deferral Rules PFIC Rules Definition of PFIC: Income test - 75% or more of its gross income is passive; or Assets test - 50% or more of the value of its assets generate passive income. "Look through rule" In applying each of the tests, income or assets of any foreign corporation in which the potential PFIC owns 25% or more of the stock are also taken into consideration. The combined income or assets need to meet the thresholds in order for the corporation to be considered a PFIC. No minimum shareholder ownership requirements. Exception from PFIC status start-up corporations where the concentration of passive income is atypical (only during the 1 st taxable year of operations in which the corporation earns gross income). 31
US Anti-Deferral Rules PFIC Rules A US shareholder in a PFIC is generally taxed on any dividend income or capital gain as follows: an excess dividend distribution (which exceeds the "normal" level of the PFIC's distributions) or a capital gain upon sale of PFIC shares is treated as having been received ratably over the period in which the US shareholder has held the stock (irrespective of when the income was actually earned) and is taxed at the highest marginal rates applicable to those years. an interest charge is imposed as an additional tax liability at the time of repatriation of the PFIC's income to the US. The interest charge is imposed only on the tax liability calculated with respect to amounts attributed to preceding years. 32
US Anti-Deferral Rules PFIC Rules Alternatively a US shareholder can elect to have the PFIC treated as a "Qualified electing fund" - Under such an election, the electing shareholder must include in income, currently, its share of the PFIC's ordinary income and capital gains. The current inclusion eliminates the deferral advantage and, therefore, later distributions by the PFIC and/or capital gains derived from the sale of the PFIC stock are not subject to the interest charge. The election by one shareholder does not affect any other shareholder. The shareholder in a qualified electing fund can also elect to defer its tax liability on undistributed PFIC income (with interest at the actual rates applicable) until a distribution is actually made "Once a PFIC, always a PFIC" once a corporation is classified as a PFIC while a US person is a shareholder in the corporation, it remains a PFIC for later years as to that shareholder, even if it does not meet the definitional tests in those years. 33
Transfer Pricing Rules General The objective of Transfer Pricing is to ensure that transactions between related parties are set under terms that would have been set in an unrelated transaction: The Arm's length principle Transfer prices should be based on the Arm's length principal: Provides benchmark standard for all transfer pricing analyses "Arm's length" requires comparison with what an unrelated party would have done under the same circumstances Implementation by using a number of methods (see further below) Best Method Rule the best method rule for testing the results of a controlled transaction is the method that, under the facts and circumstances, provides the most reliable measure of an arm's length result, relative to all potentially applicable methods: Looking for most appropriate benchmark of an arm's length price; Requires comparative analysis of alternative methods; and Absolutely no priority given to any method. 34
Transfer Pricing - Steps To A Transfer Pricing Policy Functional analysis - the FACTS Industry analysis (external factors that affect pricing and profits) Comparable data Pricing method selection Documentation Implementation Monitoring 35
Transfer Pricing The Different Methods Traditional Transactional Methods: Comparable Uncontrolled Price "CUP" (goods) or Comparable Uncontrolled Transaction "CUT" (intangibles) - actual prices Cost Plus Method; or Resale Price (goods) Transactional Profit Methods Profit Split - formula based - arguably not an arm's length method Comparable Profit Method "CPM" (US) - net profit before interest and taxes Unspecified methods US regulations allow the use of any other method as long as the taxpayer can show that it is the most reliable benchmark of arm's length results 36
Transfer Pricing The Different Methods Multiple Methods In a perfect world, there would be no conflict between the results obtained from any combination of methods In complex cases, more than one method should be used to test the result Secondary methods should be specified that support the conclusions drawn from the primary method Choice of Method In practice, choice of method is a trade-off between the theoretical purity of the best economic measure and the practicalities of what reliable information can be obtained. 37
Transfer Pricing Arm's Length Range Gross Profit 15% No Adjustment 13.7% 13.2% Arm's Length Range 10% 9.5% 9.7% 7.7% 5% 0% Controlled Taxpayer 38 Uncontrolled Comparables
Transfer Pricing Arm's Length Range Gross Profit 15 % Adjustment to the mid-point 13.7% 13.2% Arm's Length Range 10 % 10.7% 9.7% 7.7% Adjustment 5% 6.8% 0% Controlled Taxpayer Uncontrolled Comparables 39
Transfer Pricing Documentation Requirements Documentation Requirements Intended to demonstrate that the taxpayer had a reasonable belief that its tax return reflects Arm's Length prices Contemporaneous documentation must be given to IRS within 30 days of a request 40
Transfer Pricing Penalties Transactional penalty: 20% of underpayment of tax if transfer price is: 200% or more than arm's length, or 50% or less than arm's length 40% of underpayment of tax if transfer price is: 400% or more than arm's length, or 25% or less than arm's length 41
Transfer Pricing Penalties Net Section 482 Adjustment Penalty: 20% of underpayment of tax if net increase in taxable income exceeds: $5 million or 10% of gross receipts 40% of underpayment of tax if net increase in taxable income exceeds: $20 million or 20% of gross receipts underpayment must exceed $10,000 Penalty applies unless increase in taxable income is: below the applicable threshold, attributable to reasonable cause and good faith, or attributable to certain transactions between foreign corporations 42
Transfer Pricing Planning Tool Transfer Pricing affects: Performance measurement Investment decisions Cash flow Income taxes Objectives that can be achieved by a Transfer Pricing: Avoid double taxation Manage effective tax rate Business strategies: e.g., cash repatriation Minimize administration costs Provide for dispute resolution 43