Principles of Taxation
Chapter 12
Jurisdictional Issues in
Business Taxation
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Jurisdictional Issues
Slide 12-2
 Nexus - the right to tax
 Apportionment
 Permanent establishment in foreign country
 Worldwide taxation and foreign tax credits
 Blending high and low tax income
 Branch versus subsidiary
 Preventing abuse: Subpart F and transfer
pricing
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State and Local Tax
Slide 12-3
 Taxation requires nexus - degree of contact
between business and state
 legal domicile (there is nexus in the state
where incorporated).
 physical presence: employees or real or
personal property. (sales reps do not create
nexus).
 economic nexus: regular commercial activity law still unclear.
 Other issues: catalog sales, internet sales.
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Apportionment of state
income
Slide 12-4
 How determine State X’s share of Corporation
C’s taxable income?
 Under UDIPTA model, apportion based on 3factor weights:
 sales
 payroll
 property
 About 1/2 of the state double-weight sales.
This favors in-state businesses.
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International Business
Transactions - jurisdiction
Slide 12-5
 Tax treaties govern the jurisdiction to tax as
well as exceptions related to tax rates.
 Business activities are taxed by country of
residence (incorporation) unless the firm
maintains a permanent establishment.
 fixed location, such as an office of factory,
with regular commercial operations.
 typically does not result from mere
exporting
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International jurisdiction continued
Slide 12-6
 Double taxation may result from two
jurisdictions claiming right to tax the same
income.
 U.S. taxes the worldwide income of its
resident taxpayers (e.g., corporations legally
incorporated in the United States).
 If the U.S. corporation has a branch that is
doing business as a permanent establishment,
both the foreign country and the U.S. will tax
the branch income.
 What relief exists for double taxation?
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The Foreign Tax Credit
Slide 12-7
 In the U.S. (and other major trading partners),
the relief comes from a foreign tax credit.
 Applies only to INCOME taxes.
 Reduce U.S. taxes by foreign income taxes
paid.
 These rules are extremely complex, but this
chapter teaches the basics.
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Foreign tax credit limitation
Slide 12-8
 The U.S. will only grant a credit up to the U.S.
tax rate X foreign source taxable income.
 Equivalently, FTC limit = U.S. tax X foreign
income / worldwide income.
 If the firm has paid more foreign tax than the
FTC limit, 2 year carryback, 5 year
carryforward.
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FTC Planning
Slide 12-9
 Firms can cross-credit between high- and lowtax rate country income.
 Without cross-crediting, here’s the problem:
 Pay tax on income in Japan branch at 50%
of $100, only claim $35 FTC.
 Pay tax on income in Ireland branch at 10%
of $100, only claim $10 FTC.
 Total U.S. tax on $200 x 35% = $70 - $45
FTC = $25 U.S. tax paid + $60 foreign tax
paid = $85 total worldwide tax burden.
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FTC Planning - cross credit
Slide 12-10
 With cross-credit, you combine all similar
type foreign source income to compute
limitation:
 FTC limit = $70 US tax X $200 foreign income
/ $200 worldwide income = $70.
 Total U.S. tax on $200 x 35% = $70 - $60 actual
foreign taxes paid = $10 U.S. tax paid + $60
foreign tax paid = $70 total worldwide tax.
Irwin/McGraw-Hill
©The McGraw-Hill Companies, Inc., 2000
FTC for Alternative
Minimum Tax
Slide 12-11
 FTC has an additional limit for AMT
purposes:
 FTC cannot exceed 90% of tentative minimum
tax.
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Organizational Forms - direct
taxation
Slide 12-12
 FSC - an ‘paper’ entity incorporated overseas
that qualifies the U.S. parent for special tax
exemption on export sales.
 Foreign branch or partnership - the U.S.
corporation is fully taxed on branch or (share
of) partnership income.
 The U.S. corporation has a direct foreign tax credit
for income taxes paid by branch or partnership.
 The export operation, branch or partnership may be
owned by any entity in the domestic group: e.g.by a
U.S. headquarters corporation or by a separate
domestic subsidiary created by that purpose.
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Organization Forms - foreign
subsidiary
Slide 12-13
 The foreign sub is NOT part of the
consolidated U.S. return.
 The U.S. does not generally have the right to
tax subsidiary income until it is paid back to
the U.S. parent company (“repatriated”).
 When a dividend is repatriated out of aftertax earnings:
 the dividend is foreign source earnings
 the dividend is “grossed-up” (add back tax) to a
pre-tax amount
 the associated tax generates a “deemed-paid”
foreign tax credit.
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Deemed-paid credit example
Slide 12-14
 USCo pays tax at 35%. UKSub pays tax at 40%.
 UKSub earns $100 pretax, pays tax of $40 and has
after-tax earnings of $60.
 If UKSub pays a dividend of all the after-tax
earnings of $60, the dividend is “grossed-up” to
the pre-tax amount of $100.
 USCo has $100 of foreign source income, but may
claim a FTC of $40 subject to the FTC limitation.
 If this is the only foreign source income, USCo
would be limited to $35 of FTC.
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Deferral of U.S. Tax
Slide 12-15
 Because foreign subsidiary income is not
taxed in the U.S. until repatriated, large tax
savings result from earning income in low-tax
countries and delaying repatriation.
 U.S. tax is deferred until repatriation.
 Under U.S. GAAP (APB Opinion 23), firms
can avoid recording deferred tax if they state
that the earnings are “permanently
reinvested.”
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Deferral creates incentives
for tax avoidance
Slide 12-16
 Tax deferral creates incentives to shift income
artificially into low-rate countries (“tax
havens”). Examples:
 Place cash in Bermuda subsidiary bank
account - earn interest tax-free.
 Sell goods at low prices to Cayman Islands;
resell at high prices to foreign customers earn tax-free profit.
 U.S. law prevents above abuses. Subpart F
income (like examples above) earned by
controlled foreign corporations is taxable
immediately.
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Transfer pricing
Slide 12-17
 Where SubpartF rules do not apply, firms can
engage in some shifting between entities
through transfer prices. Examples:
 Pay royalties from high-tax entities to low-tax
entities.
 Charge higher prices to high-tax entities for goods
and services.
 Pay management fees from high-tax entities to lowtax entities.
 IRS has broad powers under IRC Section 482
to reallocate income to correct unrealistic
prices.
Irwin/McGraw-Hill
©The McGraw-Hill Companies, Inc., 2000