Chapter 13
Multijurisdictional
Taxation
Taxation of Business Entities
© 2012 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)
• VoiceCo, 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, VoiceCo 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)
• VoiceCo 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 VoiceCo subject to income taxes in foreign countries?
– Must it pay U.S. income taxes on the profits from its
foreign sales?
– What if VoiceCo 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)
• Suppose that VoiceCo establishes a manufacturing
plant in Ireland.
– VoiceCo incorporates the Irish operation as VoiceCoIreland, a controlled foreign corporation (CFC).
• So long as VoiceCo-Ireland does not distribute profits
to VoiceCo, will the profits escape U.S. taxation?
• What are the consequences to VoiceCo 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
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
7
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)
8
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
9
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
10
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
11
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
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The Big Picture – Example 8
Income Sourcing (slide 1 of 2)
• Return to the facts of The Big Picture on p. 13-2.
• Assume that VoiceCo makes an overseas
investment and generates $2 million of gross
income and a $50,000 expense, all related to
real estate sales and rental activities.
• The expense is allocated and apportioned using
gross income as a basis.
The Big Picture – Example 8
Income Sourcing (slide 2 of 2)
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
15
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
16
The Big Picture – Example 9
Apportionment Of Interest Expense
• Return to the facts of The Big Picture on p. 13-2.
• Assume that VoiceCo generates U.S.- source and foreign-source gross
income for the current year.
• VoiceCo’s assets (tax book value) are as follows.
Assets generating U.S.-source income
Assets generating foreign-source income
$18,000,000
5,000,000
$23,000,000
• VoiceCo 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.
$5,000,000 (foreign assets)
$23,000,000 (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 for foreign taxes paid
• 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 for 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
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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
19
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.
20
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
21
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)
22
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 must include $50,000 in gross income for the gross
up adjustment if FTC is elected
23
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 2nd and 3rd tier foreign corps if
10% ownership requirement is met at the 2nd and 3rd
levels
• Credit is also available for 4th through 6th tier foreign
corps if additional requirements are met
24
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
25
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
26
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)
• Any FTC carryforwards into post-2006 years
are assigned to one of these two categories
27
The Big Picture – Example 14
Foreign Tax Credit Limit (slide 1 of 2)
• Return to the facts of The Big Picture on p. 13-2.
• Assume that VoiceCo invests in the bonds of nonU.S. corporations.
• VoiceCo’s worldwide taxable income for the tax year
is $1,200,000, consisting of
– $1,000,000 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 14
Foreign Tax Credit Limit (slide 2 of 2)
• VoiceCo’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, VoiceCo’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 3)
• Pro rata share of Subpart F income generated
by a controlled foreign corporation (CFC) is
currently included in income of U.S.
shareholders
30
Controlled Foreign Corporations
(slide 2 of 3)
• 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
31
Controlled Foreign Corporations
(slide 3 of 3)
• 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
32
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.
33
Transfer Pricing Example
(slide 2 of 3)
34
Transfer Pricing Example
(slide 3 of 3)
35
Inbound Issues
• 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
36
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
37
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
38
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
39
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
40
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
41
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
42
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
43
Computing State Income Tax Liability
44
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
45
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
46
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
47
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
48
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
49
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
50
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
51
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
52
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
53
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
54
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
55
Payroll Factor (slide 2 of 3)
• Compensation includes wages, salaries,
commissions, etc
– Some states exclude amounts paid to corporate
officers
– Some states require that deferred compensation
amounts be included in the payroll factor (e.g.,
401(k) plans)
56
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
57
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
58
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
59
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
60
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
$400,000
Allocable income
100,000
-0Total state taxable income
$500,000
$400,000
61
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
X
$400,000 $100,000
40%
10%
90,000 150,000
30%
50%
120,000
240,000
30%
60%
Y
$500,000
50%
60,000
20%
40,000
10%
Total
$1,000,000
300,000
400,000
62
Apportionment Example
(slide 2 of 2)
Taxable income for year (all states)
$100,000
State:
Sales
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%
40%
30%
30%
140%
35%
$35,000
$125,000
$40,000
Y
50%
N/A
N/A
N/A
50%
50%
$50,000
63
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
$1,000,000
Factor
40%
10%
50%
Payroll:
30,000
30,000
240,000
300,000
Factor
10%
10%
80%
Property:
40,000
40,000
320,000
400,000
Factor
10%
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
64
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%
10%
30%
10%
$10,000
Y
50%
N/A
N/A
N/A
50%
50%
$50,000
65
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
66
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 %)
67
Refocus On The Big Picture (slide 1 of 3)
• Now you can address the questions about
VoiceCo’s activities that were posed at the
beginning of the chapter.
• Simply selling into a foreign jurisdiction may
not trigger any overseas income tax
consequences
– But, such income is taxed currently to VoiceCo in
the United States.
Refocus On The Big Picture (slide 2 of 3)
• When VoiceCo sets up a CFC in Ireland, it benefits
from deferral.
– As long as the income is not distributed to
VoiceCo and as long as the income is not
‘‘tainted’’ Subpart F income, VoiceCo can avoid
taxes on the profits of VoiceCo-Ireland.
– If VoiceCo 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?
• VoiceCo is considering building a new manufacturing facility
in another state in the United States.
– How will VoiceCo’s expansion decision be affected by state tax
considerations?
• In making the decision to expand, VoiceCo 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
PowerPoint Presentation for South-Western Federal
Taxation, please contact:
Dr. Donald R. Trippeer, CPA
trippedr@oneonta.edu
SUNY Oneonta
© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
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