Principles of Taxation

1
Principles of Taxation

• Chapter 12
• Jurisdictional Issues in Business Taxation

2
Jurisdictional Issues

• 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

3
State and Local Tax

• Taxation requires nexus - degree of contact
  between business and state.
• Having nexus in the state where incorporated is
  due to ___________ domicile.
• What creates physical presence nexus?
• Economic nexus regular commercial activity - law
  still unclear.
• Other issues Catalog sales, internet sales.

4
Apportionment of State Income

• How to determine State Xs share of Corporation
  Cs taxable income?
• Under UDIPTA model, apportion based on factor
  weights
• About 1/2 of the state double-weight _______.
  Does this favor or hurt in-state businesses?

5
International Business Transactions - Jurisdiction

• 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______________ ______________.
• Fixed location, such as an office of factory,
  with regular commercial operations.
• Typically does not result from mere exporting.

6
International Jurisdiction - Continued

• Double taxation may result from two jurisdictions
  claiming right to tax the same income.
• U.S. taxes the _______________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, who
  gets to tax the branch?
• What relief exists for double taxation?

7
The Foreign Tax Credit

• In the U.S. (and other major trading partners),
  the relief comes from a foreign tax credit.
• Applies only to what kind of taxes?
• Reduce U.S. taxes by foreign income taxes paid.
• These rules are extremely complex, but this
  chapter teaches the basics.

8
Foreign Tax Credit Limitation

• The U.S. will only grant a credit up to the U.S.
  tax rate X foreign source taxable income.
• Equivalently, FTC limit ________tax X ________
  income / _________income. Why are these
  equivalent?
• If the firm has paid more foreign tax than the
  FTC limit, ___year carryback, ____ year
  carryforward.

9
FTC Planning

• Firms can cross-credit between high- and low-tax
  rate country income.
• Without cross-crediting, heres the problem
• Pay tax on income in Japan branch at 50 of 100,
  only claim _____ FTC.
• Pay tax on income in Ireland branch at 10 of
  100, only claim _____ FTC.
• Total U.S. tax on 200 x 35 __________ -
  _____ FTC 25 U.S. tax paid _____ foreign
  tax paid 85 total worldwide tax burden.

10
FTC Planning Cross-Credit

• 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 ________.
• Total U.S. tax on 200 x 35 70 - _____
  actual foreign taxes paid ____ U.S. tax paid
  ____ foreign tax paid _____ total worldwide
  tax.

11
FTC for Alternative Minimum Tax

• FTC has an additional limit for AMT purposes.
• FTC cannot exceed ______ of tentative minimum
  tax.

12
Organizational Forms - Direct Taxation

• FSC - a 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.

13
Organizational Forms - Foreign Subsidiary

• Can a foreign sub be part of the consolidated
  U.S. return?
• When does the U.S. generally get to tax income
  earned by foreign subs?
• When a dividend is repatriated out of after-tax
  earnings
• the dividend is foreign source earnings.
• the dividend is grossed-up. What does this
  mean?
• the associated tax generates a deemed-paid
  foreign tax credit.

14
Deemed-Paid Credit Example

• 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 ____ subject to the FTC
  limitation.
• If this is the only foreign source income, USCo
  would be limited to ____ of FTC.

15
Deferral of U.S. Tax

• 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.

16
Deferral Creates Incentives for Tax Avoidance

• 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.

17
Transfer Pricing

• 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
  low-tax entities.
• IRS has broad powers under IRC Section 482 to
  reallocate income to correct unrealistic prices.