16-1 ©2011 Pearson Education, Inc. Publishing as Prentice Hall

16-1©2011 Pearson Education, Inc. Publishing as Prentice Hall

16-2

U.S. TAX OF FOREIGN-RELATED TRANSACTIONS

(1 of 2)

Jurisdiction to taxTaxation of U.S. citizens &

resident aliensTaxation of nonresident aliensTaxation of U.S. businesses

operating abroad

©2011 Pearson Education, Inc. Publishing as Prentice Hall

16-3

U.S. TAX OF FOREIGN-RELATED TRANSACTIONS

(2 of 2)

Tax planning considerationsCompliance and procedural

ConsiderationsFinancial statement implications


16-4

Jurisdiction to Tax

U.S. authority to tax foreign-related transactions based on three factorsTaxpayer’s country of citizenshipTaxpayer’s country of residenceLocation where the income is

earned


16-5

Taxation of U.S. Citizens and Resident Aliens

U.S. citizens and resident aliens taxed on worldwide income

Income earned in foreign countries or U.S. possessions receives special treatment

Foreign tax creditForeign earned exclusion


16-6

Foreign Tax Credit (FTC)(1 of 5)

FTC permits U.S. citizens and residents to avoid double taxation

FTC directly reduces U.S. tax liability

Creditable taxesTaxes paid or accrued in foreign

countryU.S. citizens and residents eligible


16-7


Translation of foreign tax paymentsCash basis taxpayers use exchange

rate on date of paymentAccrual taxpayers use average

exchange rate for the year


16-8


FTC limited to lesser of Foreign tax actually paid OR

foreign taxable income U.S. taxworldwide taxable income x liability


16-9


FTC deducted after nonrefundable credits

Unused FTC carried back one year and forward ten years on a FIFO basis to a year where taxpayer has an excess credit limitation

Source of income rules on p. 6Used to determine numerator of

FTC formula©2011 Pearson Education, Inc. Publishing as

Prentice Hall

16-10


Special FTC limitationTwo separate baskets of income

1)Passive income and 2)general limitation income

Foreign tax credit calculated for each basket of income

Excess FTC from one basket cannot offset excess limitation amounts in another basket


16-11

Foreign Earned Income Exclusion (FEI) (1 of 5)

FEI available to U.S. citizens and resident aliens working abroad

EligibilityBona fide resident test

Resident of foreign country uninterrupted for entire tax year and maintain tax home in foreign country


16-12


Eligibility (continued)Physical presence test

Taxpayer must be physically present in a foreign country for 330 full days during a 12-month period, AND

Maintain a tax home in a foreign country during that period


16-13


Foreign earned incomeWages, salaries, & fees as

compensation for personal services actually rendered

Amount of exclusionLesser of

$91,500, ORForeign earned income for current year, OR

$250.68 ($91,500/365 days) x # of qualifying days in current year


16-14


Additional exclusion for taxable housing allowanceLimitation lesser of

[Actual housing cost] – [16% x $91,500], OR

($40.11/day) x (qualifying days/365), OR(14% x $91,500) = $14,640

Housing costs incurred in excess of $14,640 are a for AGI deduction if not provided by employer©2011 Pearson Education, Inc. Publishing as

Prentice Hall

16-15


Housing allowance exclusion (continued)Allowance limited to lesser of

employer-provided amount or the individual’s FEI

Housing allowance exclusion reduces amount eligible for FEI exclusion

You can claim either the FTC or FEI exclusion on foreign earned income, but not both


16-16

Taxation of Nonresident Aliens

Resident/nonresident definitionsInvestment incomeTrade or business incomeCalculating US income tax


16-17

Resident/Nonresident Definitions

(1 of 2)

Resident aliens are taxed same as U.S. citizens

Nonresident aliens generally taxed only on U.S. source income

Taxpayer is a resident alien if they meet one of the two tests

©2011 Pearson Education, Inc. Publishing as

Prentice Hall

16-18

Resident/Nonresident Definitions

(2 of 2)

Green-card testPermanent resident w/ “green

card” visa Physical presence test

Present 31 days during current calendar year AND present 183 weighted average days during a three year periodCurrent year: 1 day counted as 1 dayPrior year: 1 day counted as 1/3 day 2nd prior year: 1 day counted as 1/6

day


16-19

Investment Income(1 of 2)

Most U.S. source passive or investment income is taxed at 30%30% applied to gross amountU.S. payer must withhold tax

U.S. payer responsible for tax if not withheld

Tax rate often reduced by tax treaties

©2011 Pearson Education, Inc. Publishing as

Prentice Hall

16-20

Investment Income(2 of 2)

Income exempt from U.S. taxationNon-USToB capital gains if individual

physically present < 183 days during year

Non-USToB interest from banks or other financial institutions not taxed

Portfolio interestIncome from casual sale of personal

property©2011 Pearson Education, Inc. Publishing as

Prentice Hall

16-21

Trade or Business Income

U.S. Trade or business (USToB)Conducting business in US on

regular basis with intent to make a profit

Income exempt from US tax ifIn U.S. <90 days/yr, employed by

nonresident entity, and earn <$3,000

Real estate income may be treated as USToB instead of passive income


16-22

Calculating U.S. Income Tax

Individuals must itemize deductionsCannot claim standard deduction

Normal deductions apply for items “effectively connected” to a USToBGains from real property considered

“effected connected” to a USToBTax treaties often reduce or

eliminate U.S. for many types of income


16-23

Taxation of U.S. Businesses Operating

Abroad

Domestic corps & Foreign branches

Foreign corporationsDeemed paid foreign tax creditControlled foreign corporationsInversions§482 rules and tax avoidanceForeign Sales Corporations &

Extra-territorial Income Exclusion


16-24

Domestic Corporations

Domestic subsidiary corporationsCan file consolidated return

w/parentParent protected from foreign

creditors of subsidiaryForeign branches

Income and losses taxed currentlyEligible for direct FTC (described

earlier)


16-25

Foreign Corporations

If domestic corp owns 10% of foreign corp, domestic corp eligible for “deemed paid credit” for dividends received from foreign corp

10% domestic corp owner cannot claim DRD on non-USToB earnings

U.S. tax on foreign sub’s income deferred until dividends received


16-26

Deemed Paid Foreign Tax Credit

Separate basket if own ≥ 10% & ≤ 50%Called Sec. 902 or 10/50 dividendsDiv paid to

domestic corp from undistrib

earnings

All undistributed

earnings

XCreditable taxes paid or accrued by foreign

corp

=Deemed

paid foreign

tax credit


__________________

16-27

Controlled ForeignCorporations (CFC) (1 of 3)

Typical tax-avoidance scenario of a CFC

U.S.

ManufacturingCorporation

(Chicago)

Foreign SalesSubsidiary

(Island Corporation)

ForeignPurchasers

of U.S.Manufacturer’s

Products

Billing of tax haven sales

subsidiary by U.S. manufacturer

Billing of foreign purchasers by tax

haven sales subsidiary

Physical flow of goods


16-28


CFC definition> 50% of foreign corp stock owned by

U.S. shareholdersU.S. shareholder defined if owns 10% of

stock

Some income forms (Subpart F income) of the CFC are taxed in the year in which they are earnedSee Figure 2 ©2011 Pearson Education, Inc. Publishing as

Prentice Hall

16-29


Tax-deferred earnings can be taxed under Subpart F when invested in U.S. property

Previously taxed income distributed tax-free

Special rules apply to the sale or exchange of CFC stock


16-30

§482 Rules & Tax Avoidance(1 of 3)

Tax avoidance opportunity high for domestic parent and 100% owned subsidiary (see slide 16-26)U.S. parent sells goods/services at

less than FMV to 100% foreign sub, OR

Foreign sub pays less than FMV for use of U.S. parent’s intangibles (e.g., patents)


16-31


§482 authorizes IRS to distribute, apportion, or allocate gross income, deductions, credits or allowances between or among controlled entities


16-32


§482 Regs hold that transactions between entities must meet arm’s-length standardConsistent w/ transactions

between uncontrolled entitiesComparable transaction under

comparable circumstances


16-33

Inversions (1 of 3)

U.S. corps subject to U.S. tax on worldwide (WW) income, while foreign corps only taxed on U.S. source income

This encourages U.S. corps with substantial foreign-source income to reorganize in a foreign country through an inversion


16-34

Inversions (2 of 3)

Basics of inversions1.U.S. corp merges into a foreign

entity or transfers its assets to a foreign entity

2.Owners of U.S. corp exchange U.S. corp’s stock for equity in foreign entity

3.Same owners continue to conduct both U.S. and foreign business through the new foreign entity, but only U.S. source business subject to U.S. taxation


16-35

Inversions (3 of 3)

§§367 & 7874 added to prevent erosion of U.S. tax base

Under §367 a foreign corp (FC) will be deemed to be a U.S. corp if

FC acquired all assets of U.S. corp Former U.S. corp s/hs own ≥80% of

FC & FC does not conduct much business

in foreign country of incorporation©2011 Pearson Education, Inc. Publishing as

Prentice Hall

16-36

Tax Planning Considerations

(1 of 2)

Deduction vs. credit for foreign taxesDeduction may be beneficial when

taxpayer has foreign losses or when credit is limited

Election to accrue foreign taxesCash method taxpayers can elect

to accrue foreign taxesBinding for all tax years and can only

be revoked with IRS consent©2011 Pearson Education, Inc. Publishing as Prentice Hall

16-37

Tax Planning Considerations

(2 of 2)

Special earned income electionsTaxpayers may revoke election to

exclude foreign-earned income whenEmployed in foreign country where

foreign tax rate > U.S. tax rate ORTaxpayer incurs substantial loss from

overseas employment


16-38

Compliance and Procedural

Considerations (1 of 2)

Foreign operations of U.S. corpForm 1120 Schedule N

Foreign tax creditForm 1118 (corp), Form 1116

(individual)Foreign earned income exclusion

Form 2555 or 2555-EZ


16-39

Compliance and Procedural

Considerations (2 of 2)

Nonresident aliens Form 1040-NR

Foreign corporationsForm 1120-F


16-40

Financial Statement Implications

(1 of 2)

Foreign tax creditExcess FTC creates deferred tax

assetDeferred foreign earnings

Normally would create a deferred tax asset


16-41

Financial Statement Implications

(2 of 2)

Deferred foreign earnings (continued)ASC 740 (SFAS 109) exception for

indefinite reinvestmentNo deferred tax asset unless

temporary difference expected to reverse in forseable future


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16-42©2011 Pearson Education, Inc. Publishing as Prentice Hall

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16-1 ©2011 Pearson Education, Inc. Publishing as Prentice Hall