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Principles of Taxation


Worldwide taxation and foreign tax credits ... Taxation requires nexus - degree of contact between business and state ... ( sales reps do not create nexus) ... – PowerPoint PPT presentation

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Title: Principles of Taxation

Principles of Taxation
  • Chapter 12
  • Jurisdictional Issues in Business Taxation

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

State and Local Tax
  • Taxation requires nexus - degree of contact
    between business and state
  • legal domicile (there is nexus in the state where
  • 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.

Apportionment of state income
  • How determine State Xs share of Corporation Cs
    taxable income?
  • Under UDIPTA model, apportion based on 3-factor
  • sales
  • payroll
  • property
  • About 1/2 of the state double-weight sales. This
    favors in-state businesses.

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 permanent establishment.
  • fixed location, such as an office of factory,
    with regular commercial operations.
  • typically does not result from mere exporting

International jurisdiction - continued
  • 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?

The Foreign Tax Credit
  • 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.

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 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.

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 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.

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 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.

FTC for Alternative Minimum Tax
  • FTC has an additional limit for AMT purposes
  • FTC cannot exceed 90 of tentative minimum tax.

Organizational Forms - direct taxation
  • 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
  • The export operation, branch or partnership may
    be owned by any entity in the domestic group a U.S. headquarters corporation or by a
    separate domestic subsidiary created by that

Organization Forms - foreign subsidiary
  • 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 after-tax
  • 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.

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 40 subject to the FTC limitation.
  • If this is the only foreign source income, USCo
    would be limited to 35 of FTC.

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.

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.

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
  • 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.