Taxation of International Transactions

General Tax Provisions

• US Individuals– Gross Income– Business Deductions– Personal Deductions– Personal Exemptions= Taxable Income X Tax Rates (about 40%)= Basic Tax – Tax credits = Net tax liability

General Tax Provisions • US Corporate Tax

– Gross Income– Business Deductions= Taxable Income X Tax Rate (35%)= Basic Tax – Tax Credits = Net tax liability

Dividends: Not deductibleTaxable to individual shareholdersDividend received deduction to corporate

shareholders

General Tax Provisions

• Transparent Entities– Partnerships– Limited liability companies

• No tax to entities• Tax on partners or members

Role of International Law and Practice

• Jurisdiction to tax limited by customary international law

• But double taxation is permissible• Role of bilateral income tax treaties• No comity regarding tax collection in other

countries

Basic Issues for Every Country

• Domestic or Foreign Taxpayers?• Source of Income• Tax on Profits of Inbound Transactions• Tax on Profits of Outbound Transactions• Defense Mechanisms against Abuse of Rules• Role of International Tax Treaties

Domestic of Foreign Taxpayer?

• Consequences under U.S. law• Domestic taxpayer: rule of worldwide

taxability• Foreign taxpayer: Any U.S.-source income?

WE/THEY

• U.S. taxpayers:U.S. citizensResident aliens

“Substantial Presence Test”U.S. corporations

• Foreign taxpayers:– Non-resident aliens– Foreign corporations

Source of Income

• Compensation: Where services rendered• Dividends: Depends upon corporation paying• Interest: Residence of borrower• Rent: Location of property• Royalties: Whose law protects• Sale of real property: Location of property

Source of Income

• Sale of personal property:– Residence of taxpayer– Inventory: Title Passage Test– Production and sale of inventory:

• Place of production• Title passage test

Source of Income

• No statutory rule: Reason by analogy

• Alimony:– No statutory rule– Like interest?– Like compensation?

Inbound Tax Regimes

• US Trade or Business– Net income @ Usual

Rates

• USTB?– Provide services in US– “Regular, Continuous

Substantial” business activiites

• Passive Income– Gross Income @30

percent

• Withholding tax mandatory

Inbound Tax Regimes

• All USTB’s combined• Business A $1,000,000; Business B ($400,000)

Tax on $600,000• But two regimes separate• Business A $1,000,000; FDAP $100,000 Tax is

$350,000 + $30,000 = 380,000• But Business A ($1,000,000); FDAP $100,000

Total tax is $30,000

Branch Profits tax

US Branch• Brazco operates• Texas branch• Net income of branch at

35%• No tax on repatriation

because no incomeBut now: branch profits tax of 30% on repatriation

US Subsidiary• Brazco owns Texas

subsidiary• Texco pays 35% tax on net

income• 30% withholding tax on

dividends

Impact of Treaties on Inbound Taxation

• FDAP Income Regime:• Withholding taxes are reduced or eliminated

on a reciprocal basis• Business income: • Only taxed if operated through a “permanent

establishment”

Tax Planning

• Plan A: Invest $10,000,000 in stock of US Sub– Tax on net income– 30% tax on dividends, which are not deductible

• Plan B: Invest $1,000 in stock; Lend $9,999,000 @ 20 percent interest; payable when enough cash; subordinated to all other claims

Plaza del Tax Toros

IRS TAXPAYER

Plaza del Tax Toros

• Red Flags:– Debt to Equity Ration– No absolute obligation– Interest rate too high– Subordination put in same position as shareholder

– Net result: Thin capitalization doctrine

Taxation of Outbound Transactions

• Alternatives:– Territoriality—Many countries– World Wide Taxation—US and few others– Hybrids

US Tax of Foreign Income

• Worldwide taxability• But use of foreign subsidiaries• Foreign tax credit

Foreign Tax Credit

• US tax rate 35%• Oz tax rate 20%• Oz branch income of 1,000• Oz tax of 200• US basic tax of 350 less foreign tax credit of

200 = New US tax of 150

Creditable Taxes

• Foreign “income taxes” and “excess profits taxes”

• Foreign taxes “in lieu of income taxes”– Eg, withholding taxes on investment income– Eg, taxes on assumed income

Effect of Treaty

• Commits parties to mitigate double taxation either by– Exemption– Foreign tax credit

But treaty not necessary under US law

Indirect Foreign Income Tax

• Eligibility: US corp owns at least 10% of foreign corp

• Oz sub income of 1,000• Oz tax 200• Dividend to US parent 800• US parent income: 800 + gross up of 200 =

1,000• US tax: 350 – indirect FTC 200 = 350

FTC Limitation

• Maximum FTC is US tax on foreign-source income

• Eg: Oz tax of 40%• Oz income 1,000• Oz tax 400• US income 1,000• Basic US tax 350 – FTC of 350 = 0• Excess Credit carried over for 10 years

Using Excess Credit: Cross-Crediting

• Nirvana has no income taxincome tax

Oz 1,000 400Nirvana 1,000 -0-US basic 2,000 700FTC 400Net US 300

Tax Planner’s Reward

Transfer Pricing

• Section 482 empowers IRS to recalculate result of transactions between related entities

• Enormous amounts in dispute• Possibility of double taxation because two or

more countries may be examining the same transaction

Impact of Treaties

• Mutual cooperation provision• Possible mandatory arbitration where

negotiation fails• “Baseball arbitration” supported by US

Treasury Department

Defense Mechanism• Subpart F of the Code• Controlled foreign corporations• More than 50% of voting power or value owned by “US

shareholders”• “US shareholders” own at least 10% of stock in foreign

corporation• Subpart F income subject to “constructive dividend” to

US shareholders• Subpart F income is primarily passive income and

income realized in circumstances when tax avoidance appears to be a primary objective

Subpart F Income

• Passive income• Foreign base company sales income.

– Sale between CFC and related entity– Not for use in CFC country of organization

• Foreign base company services income– Services by CFC for related entity– Not performed in CFC country of organization

Tax Law Enforcment

FATCA

• Foreign Account Tax Compliance Act– Withholding tax on payments to : “foreign

financial Institutions” who do not agree to provide information about US depositors

Base Erosion and Profit Shiting

• BEPS—Major project of OECD, authorized G7 meeting in 2012.

• Intended to increase international cooperation to defend against tax evasion.