Author: JERRY JONCKHEERE and RANDALL JANICZEK
JERRY JONCKHEERE, CPA, is a partner with Plante Moran in Grand Rapids, Michigan, specializing in international tax planning. He is also a member of the firm’s National Tax Office, which monitors current legislation and its impact on Plante Moran clients. RANDALL JANICZEK, CPA, is a senior manager with Plante Moran, specializing in international tax planning, including structuring foreign operations and foreign tax credit planning.
When a business makes the bold step of becoming internationally active, it must learn new domestic rules and reporting requirements, a new vernacular, and an understanding of how foreign countries tax local businesses and non-residents. In addition to new vernacular, new taxes, and new filing requirements, there are also new entity types and structures and new accounting challenges that must be understood. To aid client discussions, international tax-related issues are divided into seven subtopics: U.S. compliance requirements; expatriate or inpatriate taxation; cross-border issues; accounting-related issues; structuring; foreign tax credit issues; and transfer pricing. Each company will have different levels of interest and exposure to each topic.
U.S. compliance: What additional U.S. tax forms need to be filed?
As Bilbo Baggins said in The Lord of the Rings, “It’s a dangerous business going out your door. You step onto the road, and if you don’t keep your feet, there’s no knowing where you might be swept off to.” When one is swept off to new places and new business adventures, there is likely a U.S. tax form—or several—that will need to be filed. While most international forms are informational, they can carry large penalties if not completed accurately and on time. (Common penalties are $10,000 or $25,000! 1) Forms are required to report the activities of foreign subsidiaries or for transactions with foreign parents or sister corporations. Additionally, forms are also required to report the holding of foreign bank accounts or assets, or simply transactions with countries that are boycotting Israel.
To better understand U.S. forms that may be required, filing requirements can be divided into four categories: inbound investment, outbound investment, transactions, and financial. While this covers the primary tax forms, this list is not meant to be all inclusive.
Inbound investment reporting.
Inbound investment reporting is for U.S. companies that have a certain ownership threshold generally based on equity investments from foreign investors or parents. Forms that are common for inbound companies include:
- Form 5472 (Information Return of a 25 Percent Foreign-Owned U.S. Corporation or a Foreign Corporation Engaged in a U.S. Trade or Business). This form must be completed when a U.S. C corporation has transactions with a related foreign company. If there are no related transactions, there is no filing requirement, so the return may be filed one year and not required the next. (Note that the form is for C corporations only; S corporations or other flow-through 2 companies do not have to file.)
- Form 8926 (Disqualified Corporate Interest Expense Disallowed Under Section 163(j) and Related Information). This form must be filed by all U.S. C corporations that incur interest expense paid to a foreign parent. The form tests for thin capitalization3 and the deductibility of interest expense paid to related foreign companies.
- Form 1120-F (U.S. Income Tax Return of a Foreign Corporation). This return is filed by foreign corporations that have a trade or business in the U.S., have a tax liability related to FDAP income or effectively connected income (ECI),4 or are claiming treaty-based protection (Form 8833—Treaty-Based Return Position Disclosure). Foreign corporations are encouraged to file when they have more than $500,000 in royalties or other U.S. source payments5—even if no tax is owed. Failure to file Form 1120-F could be costly and depending on the actual facts and circumstances result in a gross basis tax.6
- Form 8804 (Annual Return for Partnership Withholding Tax). This form must be filed by a U.S. flow-through entity that has foreign partners or members. This form discloses the ECI allocated to the foreign partners or members by the entity and calculates the required withholding. Form 8805 (Foreign Partner’s Information Statement) reports ECI and withholding amounts to the foreign partners or members much like a Form 1099 reports various payments to a U.S. person.
Outbound reporting is for U.S. companies with foreign subsidiaries or operations. The term “outbound” is used because investment is “flowing out” of the U.S. Common forms for outbound companies include:
- Form 5471 (Information Report of U.S. Persons with Respect to Certain Foreign Corporations). This form is used to report entity information, financial data, Subpart F income (explained later), earnings and profits calculations, intercompany transactions, and changes in ownership in foreign corporations when U.S. shareholders pass 10% or greater than 50% thresholds. In general, any transaction in which a U.S. shareholder first owns 10% percent or more of a foreign corporation, or purchases or sells blocks of 10% or more, must be reported. In addition, when U.S. shareholders (that each hold 10% or more) own more than 50% of the stock of a foreign corporation, the financial data for the foreign subsidiary must be reported annually.
- Form 8865 (Information Report of U.S. Persons with Respect to Certain Foreign Partnerships). This form is similar to the Form 5471 but reports transactions and financial information of foreign partnerships. The same 10% and greater than 50% thresholds apply for transactions and financial information, respectively.
- Form 8858 (Information Return of U.S. Persons with Respect to Foreign Disregarded Entities). This form reports the financial information for foreign disregarded entities owned directly by U.S. persons or by controlled foreign corporations or partnerships.7
- Form 926 (Return by a U.S. Transferor of Property to a Foreign Corporation). This form reports the transfer of cash, assets, or intangibles to a foreign corporation and is required to report contributions of cash and assets of $100,000 or more, or the transfer of any intangible asset.
- Forms 1116 and 1118 (Foreign Tax Credit). These forms calculate the foreign tax credit for individuals and corporations, respectively. They identify the sources of foreign taxes paid and calculate foreign source income, the foreign source income limitation, and the limitation due to U.S. taxes owed.
Reporting related to transactions.
Reporting related to transactions is required when a U.S. company has transactions with foreign persons or companies, or when services are performed in the U.S. If proper forms are not filed, a U.S. company may have to pay penalties equal to 30% of the amount of the reportable payments.
- Form 1042 (Annual Withholding Tax Return for U.S. Source Income of Foreign Persons). This form (and Forms 1042-S and 1042-T) report U.S. source payments made to foreign persons. U.S. persons must identify payments made to foreign persons, report those payments, and make correct and timely withholdings on payments. While treaty exceptions may lower the default 30% withholding rate, to determine the appropriate withholding, U.S. persons must properly identify foreign persons that it pays.
- Form W-8BEN (Certificate of Foreign Status of Beneficial Owner for United States Tax Withholding). Foreign persons must complete Form W-8BEN (or one of its sister forms, Forms W-8ECI; W-8IMY; or W-8EXP) to disclose their country of residency or citizenship. U.S. persons may generally rely on the foreign person’s disclosure to identify and calculate the correct withholding rate. To qualify for a withholding rate less than 30%, foreign persons must obtain a U.S. identification number and certify eligibility for treaty benefits.
- Form 8233 (Exemption from Withholding on Compensation for Independent (and Certain Dependent) Personal Services of a Nonresident Alien Individual). Form 8233 is similar to Form W-8BEN as the form provides a U.S. person with information required to not withhold or to withhold at a lower rate for services performed by a nonresident alien individual in the U.S.
- Form 8288 (U.S. Withholding Tax Return for Dispositions by Foreign Persons of U.S. Real Property Interests). A U.S. person that purchases U.S. real estate from a foreign seller is generally required to withhold (and remit to the IRS) 10% of the amount of the purchase price on behalf of the foreign seller. This form reports the transaction and is the transmittal for the withheld amount(s).
- Form 5713 (International Boycott Report). U.S. companies that propose activities or have transactions or business in certain Middle East countries8 must file this return. The purpose of the return is to identify companies that perform a very broad list of activities9 in countries that are boycotting Israel. The form differs between proposals and activities for businesses that are not participating with the boycott and those activities for businesses that are participating with the boycott. For the former businesses, the form is informational. For the latter businesses, foreign tax credits, IC-DISC benefits, and other tax benefits may be lost.
Financial account reporting.
Financial account reporting is one of the IRS’s newest “hot buttons” as it tries to identify unreported income related to foreign assets owned by U.S. persons.
- Form TD F 90-22.1 (Report of Foreign Bank and Financial Accounts). This form reports the foreign financial accounts of U.S. persons with foreign bank accounts, foreign mutual funds, or other financial interests. While informational, this form has been the focus of IRS efforts to identify foreign holdings of U.S. persons.
- Form 8938 (Statement of Specified Foreign Financial Assets). This form, new for 2011 for individuals, requires the disclosure of all foreign assets when foreign holdings exceed $50,000. The form requires disclosures for foreign bank accounts, foreign business entities, foreign mutual funds, foreign trusts, and foreign held insurance policies.
- Form 8621 (Information Return by a Shareholder of a Passive Foreign Investment Company or Qualified Electing Fund). This form reports the activities of PFICs10 and QEFs.11 While the definition of a PFIC is extensive, the typical PFIC that requires reporting includes the formation of a foreign corporation that has no trade or business. PFICs are taxed at the highest individual or corporate rates over the period held by a U.S. person.
- Form 3520 (Annual Return to Report Transactions with Foreign Trusts and Receipt of Certain Foreign Gifts). This form (and its sister form, Form 3520-A) reports gift or inheritances from foreign persons and contributions to, withdrawals from, and financial activities of foreign trusts.
In summary, it does not matter whether one is owned by a foreign business, owns a foreign business, has transactions with a foreign business or person, or simply owns foreign assets. The IRS wants taxpayers to report virtually all information related to those activities and how they affect their U.S. income tax returns.12
Expatriate and inpatriate taxation: How will employees be taxed in foreign countries, and what must be done when non-U.S. persons are hired?
Countries generally have the right to tax workers—either as employees or as independent contractors—that are employed by a company in that country or that otherwise perform work in that country. Determining how to tax an employee who is a citizen or resident of one country and who works in another country is based on the local law of the country where the services are performed, and any treaty provisions between the country of the employee’s citizenship or residency and the country where services are performed. To complicate matters further, the income taxation of a worker may be different than the payroll tax or old-age, survivors, and disability insurance taxation of the worker because the payroll tax agreements are separate from the income tax treaties.
When U.S. employees work in a foreign country, the foreign country generally can tax individuals if: (1) they are present in the foreign country for more than 183 days in a calendar year, (2) they are employed by a company in the foreign country, or (3) they have a bona fide residence in the country. These are general rules, and local law and any relevant treaty must be understood.
U.S. persons are always required to file a U.S. return, even when they live in, and are taxed by, a foreign country. To avoid double taxation on the income, a U.S. taxpayer may in certain circumstances file Form 2555 (Foreign Earned Income) to claim a foreign income exclusion13 or, alternatively, the U.S. person may claim a foreign tax credit. The foreign income exclusion is limited to $92,900 in 2011 ($95,100 in 2012). U.S. persons earning more than $92,900, or that do not meet the requirements for the foreign income exclusion, may claim a foreign tax credit.
U.S. companies that use foreign workers—either as employees or as independent contractors—may be required to withhold payroll taxes (for employees) or remit withholding on payments paid to foreign workers performing services in the U.S. To determine withholding requirements, U.S. companies should obtain a Form 8233 (Exemption from Withholding on Compensation for Independent (and Certain Dependent) Personal Services of a Nonresident Alien Individual) to determine if a withholding requirement exists.
Cross-border issues: What issues arise when transacting business across international borders?
Internationally active businesses must also understand cross-border issues, a generic term for determining how foreign countries can—and will—tax a business. This area can become very complex because, as shown by employee taxation issues, both foreign local law and relevant treaties can have an impact on how an activity or transaction is taxed. Three cross-border issues are covered in this article:
- Treaty-based issues. The U.S. has treaties with most of its significant trading partners that cover permanent establishment, withholding, and limitation on benefit issues. It should be noted that the U.S. does not have full treaties with some important trading partners, including Brazil and Hong Kong.
- Customs-based issues. While customs is a specialized area handled by brokers and freight forwarders, businesses should be aware that shipping terms become more complex (see incoterms discussion below) and that the “importer-of-record” designation will affect certain taxes.
- Business taxes. Many countries are starting to adopt, or enforce, taxes on services performed outside their country. This development is significant as business taxes are additional costs of business as they are not creditable taxes for the U.S. foreign tax credit.
When a business forms a foreign entity, that entity is generally required to file a foreign country income tax return. When a U.S. company is active in a foreign country, it may have to file an income tax return if local law requires it or when it is deemed to have a “permanent establishment” under a relevant treaty. In general, permanent establishment requires that a company have a “fixed place of business through which the business…is wholly or partly carried on.”14 Failure to timely file a required income tax return or information return claiming treaty protection15 may result in significant penalties regardless of whether income tax is owed.
Income earned in a foreign country is often subject to withholding taxes when paid to a U.S. person. Payments of interest, dividends, and royalties are often subject to local statutory withholding rates that are often reduced by a relevant treaty.16 While withholding taxes may seem punitive, they protect a country’s taxable income base as a local business is deducting the interest or royalty without a local business claiming the income. The withholding tax is a substitute for the foreign recipient filing a local tax return.
Example: A U.S. company charges a $1,000 royalty to a Mexican company. Under the U.S.-Mexico Income Tax Treaty the Mexican company can withhold 10% of the royalty if it can establish that the U.S. company qualifies for benefits under the treaty. The Mexican company will pay $900 to the U.S. company and $100 to Mexico’s SAT.17 Because the withholding amount is treaty-based, the U.S. company
(or its shareholders if it is a flow-through entity) may claim the withholding amount as a foreign tax credit.
Most U.S. treaties contain a limitation on benefits (LOB) provision that identifies the types of individuals or entities that may receive benefits from the treaty. 18 While LOB provisions are in place to ensure that a person does not start an entity for the sole purpose of gaining treaty benefits that they would not otherwise qualify for (i.e., a U.S. company establishes a shell Luxembourg entity to gain treaty benefits), the provisions often add a level of complexity for many mid-sized businesses. While LOB provisions often provide benefits for all provisions to individuals and publicly traded companies, they require flow-through entities (i.e., LLCs or S corporations) to document that their members or shareholders qualify for benefits under the treaty. When ownership structures are complex, the documentation of shareholders can be difficult.
Customs based issues.
Most U.S. businesses hire customs specialists or contract with brokers or freight forwarders to handle the physical transporting of products and to prepare required customs documents; however, businesses must be aware of more complex shipping terms and how the importer-of-record status may result in new tax registration and filing requirements in foreign jurisdictions. Additionally, if a U.S. person is an importer of goods, the customs value must be the same as the cost basis of that inventory for income tax purposes.19
U.S. businesses are typically familiar with FOB-shipping point and FOB-destination point shipping terms used commonly in the U.S.; however, when shipping internationally, 11 standard terms, referred to as incoterms,20 are typically used. Note that FOB is both a U.S. term and an incoterm, but the two terms refer to different levels of cost and shipping responsibilities. If both parties are not speaking the same “language,” misunderstandings can result.
Lastly, a seller and purchaser may negotiate who the “importer-of-record” will be. The importer-of-record is the party designated to handle any customs duties or tariffs (though other negotiations may result in a reimbursement or sharing of any payment) and any value-added tax payments. Therefore, if a U.S. business is designated as the importer-of-record, it often must register to collect and pay value-added taxes.
While most U.S. businesses and persons are familiar with the sales and use taxes assessed by most states and some local jurisdictions, they generally are not familiar with value-added taxes (VAT) that are a key source of revenue for virtually all foreign countries. VAT is charged on virtually all transactions outside of the U.S., and, while similar to a sales tax, VAT is assessed on transactions between businesses at every level up to, and including, the final sale to the consumer. While VAT is collected at every level, a business receives credit for VAT paid to its vendors.
Exhibit 1 provides an example of a 15% VAT. An iron miner sells $1,000 of iron to a steel foundry, which sells the steel for $2,000 to an automotive OEM, which sells the car for $3,000 to its final customer. The invoicing between the parties, and required VAT collections and payments, are provided in the exhibit.
Exhibit 1. 15% VAT example
Company Bills Remits to Government Profit Kept
Iron Miner $1,000 (product) + $150 $1,150 less $150
$150 (VAT) or = $1,000
$1,150 to Steel
Steel Foundry $2,000 (product) + $150 ($300 collected $2,300 less $1,150
$300 (VAT) or from Automotive OEM less $150 = $1,000
$2,300 to Automotive less $150 paid to Iron
Automotive OEM $3,000 (product) + $150 ($450 less $300 $3,450 less $2,300
$450 (VAT) or paid to Steel Foundry) less $150 = $1,000
$3,450 to final
To summarize, the final customer pays the value-added tax, much like a sales tax in the U.S.; the government, however, collects the taxes throughout the entire production and sales process, without resulting in any additional net costs to the businesses in that process.
Foreign countries are increasingly assessing “business taxes” on payments from local businesses to U.S. businesses on royalties and/or services. While business tax withholding looks like withholding on treaty-based payments (e.g., interest, dividends, and royalties), the amounts withheld are not treated as creditable taxes for U.S. foreign tax credit purposes because they are withholdings on services performed in the U.S. and not given treaty protection. For example, China assesses a 5% tax on most services provided to Chinese companies and Chile requires withholdings of 30% on services provided to local companies.
Accounting-related issues: How to account for foreign operations or subsidiaries
Becoming internationally active often requires business transactions in foreign currencies, translating foreign financial statements,21 and applying GAAP principles to foreign income tax accounts.22 While these are GAAP-related requirements, understanding the GAAP rules is extremely important when preparing U.S. compliance returns and doing tax-required calculations, such as earnings and profits, that must be done in local currency. In addition, because many foreign countries use International Financial Reporting Standards (IFRS), which the U.S. is
considering adopting, another potentially complicating factor is added to foreign financial statements.
Tracking local currency transactions is important because foreign currency transactions give rise to realized exchange gains and losses (which are an item of taxable income), unrealized exchange gains and losses (which are not items of current taxable income) and translation adjustments. Understanding which entity recognizes the foreign currency adjustments and whether the adjustments are realized, unrealized, or translation adjustments, is an important part of correctly tracking taxable income and earnings and profits.
ASC 830 provides guidance on how foreign financial statements are translated into GAAP U.S. dollar financial statements. Understanding the translation process is important in determining the correct local currency trial balance amounts that must be used for earnings and profits calculations that are the base for virtually all foreign taxable income and tax credit calculations.
ASC 740 (formerly FAS 109) and APB 23 (now codified in ASC 740) are required for U.S.
financial statement preparation. When foreign entities or foreign operations are included in U.S. financial statements, the tax accounts (income tax expense, accrued income taxes, and deferred income taxes) must be calculated by comparing local currency GAAP trial balances to local currency tax basis records. Because U.S. assurance staff members are often unfamiliar with local tax rules, tax accountants familiar with international tax concepts will generally be called on to assist with the ASC 740 calculations.
Structuring: What to know when structuring overseas operations
Internationally active businesses must be aware of foreign structuring options and how the U.S. rules view those foreign entities. The U.S. tax system is unique when compared to foreign tax systems due to the number of U.S. options for flow-through entities. Partnerships in the U.S. and in foreign countries are default flow-through entities. The U.S., in addition to partnerships, allows LLCs and corporations that make “S Elections”23 to be treated as flow-through entities under the U.S. “check-the-box election” regime.24 In the U.S., corporations that do not make an S election are per se entities that are not eligible for a check-the-box election.25
Generally, foreign countries offer two types of limited liability entities and a partnership entity. The U.S. will typically view one of the limited liability entities as a per se entity that is ineligible for the check-the-box election. The other limited liability entity can generally make a check-the-box election in order to be treated as a flow-through entity for U.S. tax purposes. The election does not affect the local taxation of the entity.
Example: Germany has two primary limited liability entity options, an AG26 and a GmbH.27 The AG is the entity that is chosen for publicly traded companies and offers no limitations on the free transferability of shares. This lack of limitation is a differentiating factor that makes the AG a per se corporation. The GmbH is an entity that will always be taxed as a corporation in Germany, but may be treated as a foreign disregarded entity by a U.S. parent.
The check-the-box election is significant as it provides U.S. flow-through entities (an LLC or S corporation) the ability to flow-through the income from the German entity to the U.S. members or shareholders with no corporate level tax in the U.S. that may bring it with a direct foreign tax credit subject to certain limitations.
As noted above, the U.S. tax system is unique due to its ability to treat more U.S. entities as flow-through entities and, more importantly, the ability to treat foreign entities as flow-through entities for U.S. purposes. The grid in Exhibit 2 demonstrates the effective tax rates for the four structures assuming that all foreign profits are distributed. While the timing of the distributions do not matter for U.S. flow-through entities, it does matter for U.S. C corporations. A discussion of the benefits related to deferred payments from foreign entities to U.S. C corporations is outside the scope of this article.
Exhibit 2. Structures with a U.S. parent and a foreign subsidiary
In the scenarios in Exhibit 2, the effective tax rate in Germany is always 33%. The status of the U.S. parent or whether a check-the-box election is made for Germany does not affect the calculation of the tax paid by the German entity to the German Treasury. Note that it is assumed that the U.S. corporation or shareholder is able to claim all German taxes paid as a foreign tax credit.
- Scenario A: U.S. C corporation owns German controlled foreign corporation. The effective tax rate of German earnings fully paid out to U.S. shareholders is 43.90%. On $100 of earnings, Germany corporation would pay $33 to the German Treasury; U.S. corporation would pay $1 of tax to the IRS (i.e. $34 of preliminary tax less $33 foreign tax credit) when German corporation pays a dividend; U.S. shareholder will pay $9.90 (i.e. $66 dividend multiplied by 15% qualified dividend rate) when U.S. corporation pays a dividend.
- Scenario B: U.S. S corporation or LLC owns German controlled foreign corporation. The effective tax rate of German earnings fully paid out to U.S. shareholders is 43.05%. On $100 of earnings, Germany corporation would pay $33 to the German Treasury; U.S. S corporation or LLC is a flow-through entity and pays no tax; U.S. shareholder will pay $10.05 (i.e. $67 dividend multiplied by 15% qualified dividend rate) when German corporation pays a dividend to its U.S. parent.28 No further tax is owed when the U.S. S corporation or LLC makes a distribution of $67 to its shareholder or member.
- Scenario C: U.S. C corporation owns German disregarded entity. The effective tax rate of German earnings fully paid out to U.S. shareholders is 43.90%. On $100 of earnings, Germany corporation would pay $33 to the German Treasury; U.S. corporation would pay $1 of tax to the IRS (i.e. $34 of preliminary tax less $33 foreign tax credit) whether or not the German disregarded entity pays a dividend; U.S. shareholder will pay $9.90 (i.e. $66 dividend multiplied by 15% qualified dividend rate) when U.S. corporation pays a dividend.
- Scenario D: U.S. S corporation or LLC owns German disregarded entity. The effective tax rate of German earnings fully paid out to U.S. shareholders is 35%. On $100 of earnings, Germany corporation would pay $33 to the German Treasury; U.S. S Corporation or LLC is a flow-through entity and pays no tax; U.S. shareholder will pay $2 (i.e. $35 preliminary tax less $33 foreign tax credit) regardless of whether the German disregarded entity or U.S. S corporation or LLC pays a dividend. No further tax is owed when the U.S. S corporation or LLC makes a distribution of $67 to its shareholder or member.
As the scenarios above show, there is a significant advantage for U.S. flow-through entities to make check-the-box elections for their foreign entities.
Foreign tax credits: When does a taxpayer get credit on a U.S. tax return for taxes paid to a foreign country?
When an internationally active business or foreign subsidiary pays tax to a foreign treasury, the taxpayer may receive a foreign tax credit that reduces its U.S. tax burden. As noted above, a foreign tax credit depends on the taxpayer’s actual facts and circumstances including whether the entity is an individual, C corporation, S corporation, or a partnership, including an LLC taxed as a partnership. Another consideration is whether a check-the-box election was made for the foreign entity. The structuring examples above will be used to discuss available U.S. foreign tax credit methods:
- Scenario A: The U.S. C corporation receives a foreign tax credit when a dividend is paid by the foreign entity ($67 in this example). The C Corporation is allowed to either claim the actual dividend amount received as income (which will normally generate an income tax liability of $22.78 using a 34% rate) or it is allowed to “gross up”29 the dividend for the amount of foreign taxes paid ($33 in this example). Under the Section 78 gross up calculation, the C corporation will recognize $100 in income (i.e. $67 dividend plus $33 Section 78 gross up), calculate a preliminary tax of $34, and take a foreign tax credit of $33 (the Section 78 gross up is assumed to be creditable foreign taxes paid) for a net U.S. tax liability of $1.
- Scenario B: No foreign tax credit is allowed as the U.S. individual shareholder is deemed to hold foreign stock directly. Dividends paid by the foreign corporation resident in countries with treaties with the U.S., are taxable at U.S. qualified dividend rates.
- Scenario C: The U.S. corporation gets the same result as in Scenario A, but for different reasons. Because the check-the-box election has been made for the German entity, its income of $100 flows directly to the U.S. return (regardless of whether a dividend is paid or not). The U.S. C corporation calculates a preliminary tax of $34 and is allowed a foreign tax credit of $33 for a net U.S. income tax liability of $1.
- Scenario D: The U.S. shareholder picks up on his individual tax return the $100 earned by the German disregarded entity and calculates a preliminary tax of $35. The shareholder is allowed a foreign tax credit of $33 for a net U.S. income tax liability of $2.
The examples above assume that the foreign taxes paid are able to be claimed as a foreign tax credit. However, in many cases the full amount of the foreign taxes paid may not result in usable foreign tax credits as one of three limitations may apply:
(1) Foreign taxes paid: The U.S. foreign tax credit will never be larger than the foreign taxes paid.
(2) Foreign source income limitation: The U.S. foreign tax credit will never be larger than (a) the U.S. effective tax rate multiplied by (b) the foreign source income.
(3) U.S. tax obligation: The U.S. foreign tax credit will never be larger than the U.S. tax obligation.
This section provides the basics of how the U.S. foreign tax credit works. The actual mechanics will generally be more complex. There are a number of pitfalls that may accelerate the inclusion of foreign income on U.S. income tax returns (i.e. Subpart F and Section 956) and planning and structuring opportunities that may result in greater use of foreign tax credits (i.e. Section 863(b)).
Transfer pricing: How should transactions with related companies be priced?
When U.S. companies have transactions with controlled entities,30 there is often no reason for the company itself to scrutinize the allocation of the profit between the U.S. person and the foreign controlled entity. However, taxing authorities—both U.S. and foreign—have a vested interest in making sure that profits are fairly allocated between the jurisdictions that add value to the transaction. The U.S. and foreign jurisdictions generally require that companies determine an arm’s-length price based on methodologies defined in regulations31 or other guidance.32 The U.S. has penalties that apply if pricing is adjusted on audit and if documentation is not prepared contemporaneously.33 Arm’s-length pricing is required for intercompany sales or purchases of tangible products, intercompany transactions involving intangible assets, intercompany services, and intercompany financial transactions with specified methodologies for each category of transactions.
Transfer pricing is a focus for many taxing authorities around the world and proper planning and documentation are required to avoid adjustments and significant penalties. While proper planning can be complex, having an effective transfer pricing policy between related companies that is reasonable and complements the company’s structure and treasury goals can reduce audit risk and help to lower the worldwide effective tax rate. The upfront planning to reduce audit risk is also important due to the cost of fighting adjustments that involve two or more countries and their competent authorities.34
Expanding internationally can be taxing
There are a variety of tax-related concerns that companies must understand prior to going global. Yes, they can be complicated, but the right professional can help navigate the complexity to arrive at the best solutions for the business.
The IRS has several penalty provisions related to late or incomplete filing of information reports. Key statutory penalty provisions can be found at Section 6038(a)(1) for Form 5471 ($10,000 and other penalties); Reg. 1.6038A-4 for Form 5472 ($10,000 and other penalties); Section 999 for Form 5713 ($25,000). This list of penalties is not complete and represents only some of the penalties that may be applied on late or incomplete information return filings.
A “flow-through” or “pass-through” entity is a legal entity where, for tax purposes, its income “flows-through” to its shareholders, members, or partners.
Section 163(j) is the basis for U.S. thin capitalization rules. The U.S. has a two-prong test for deductibility of interest expense on foreign related party debt. The first test is based on the debt-to-equity ratio—Section 163(j)(2)(A)(ii). The second test is based on the profitability of the U.S. operations—Section 163(j)(2)(B)(i).
Foreign businesses may be taxable in the U.S. on FDAP income (income that is fixed or determinable, annual or periodic) as defined in Section 881(a)(1) as interest, dividends, rents, salaries, wages, premiums, annuities, compensations, remunerations, and emoluments earned in the U.S. by the foreign business. In addition, foreign businesses will also be taxable on income from trade or business activities “effectively connected” with the U.S. as defined in Section 864(c).
See Form W-8BEN, Part II, Question 9(e).
See Reg. 1.882-4(a)(2) requiring the filing of a tax return in order to be able to claim the benefits of any deductions. There may be reasonable cause relief for failure to file.
The reader is cautioned to review Reg. 1.1503(d)-1, et. seq. regarding the ability to deduct a loss from a disregarded entity both in the local country and in the U.S.
The Secretary of the Treasury maintains, under Section 999(a)(3) a list of countries boycotting Israel. As of July 2012, that list includes include Kuwait, Lebanon, Libya, Qatar, Saudi Arabia, Syria, United Arab Emirates, and the Republic of Yemen
The instructions to Form 5713 provide that operations include “all forms of business or commercial activities and transactions (or parts of transactions), whether or not productive of income, including, but not limited to: selling; purchasing; leasing; licensing; banking, financing, or similar activities; extracting; processing; manufacturing; producing; constructing; transporting; performing activities related to the activities above (for example, contract negotiating, advertising, site selecting, etc.); and performing services, whether or not related to the activities above.”
Section 1297 defines a passive foreign investment company (PFIC) as “any foreign corporation if (1) 75% or more of the gross income of such corporation for the tax year is passive income, or (2) the average percentage of assets (as determined in accordance with subsection (e)) held by such corporation during the taxable year which produce passive income or which are held for the production of passive income is at least 50%.”
Section 1295 allows a PFIC to make an election to be treated as a qualified electing fund (QEF). PFICs that make this election are taxed as if the foreign corporation is a flow through entity.
In essence, the IRS is looking for transparency in tax reporting due to the fact that the U.S. has a world-wide income tax system yet its major trading partners have a territorial system and/or lower tax rates providing an incentive for taxpayers to seek tax deferral or avoidance.
Section 911 allows U.S. citizens or U.S. residents living abroad to exclude up to $92,900 (for 2011) in foreign earned income if they are a bona fide resident of a foreign country or if they are present in a foreign country or countries at least 330 full days in a period of twelve consecutive months.
Convention between the United States of America and Canada with Respect to Taxes on Income and Capital – Article V.
Canada requires virtually all companies doing business in Canada to file Schedule 91 (Information Concerning Claims for Treaty-Based Exemptions) to disclose business activities in Canada. Failure to submit this form can result in a penalty of C$2,500.
The U.S. default withholding rate on interest, dividends, and withholding is 30%. For companies that qualify under the U.S.-Canada income treaty, for example, the withholding rates are reduced to 5% or 15%, 0%, and 0%, or 10% respectively, depending on ownership and types of payments.
Mexico’s equivalent of the IRS is the Servicio de Administracion Tributaria or SAT.
The LOB provision in the model U.S. treaty is largely a “creature” of the Treasury Department when negotiating treaties. Accordingly, the tax authorities of many of our treaty partners have a hard time understanding it.
See Section 1059A.
ASC 830 Foreign Currency Matters (formerly FAS52).
ASC 740 Income Taxes (formerly FAS109) and APB 23 Accounting for Income Taxes—Special Areas.
U.S. corporations are generally taxed as “C corporations” or “S corporations” named after the subchapter of the Code that they are taxed under. Subchapter S (Sections 1351-1400T) provides guidance on corporations that can make an S election, how the election is made, and how the S corporation may operate.
Reg 301.7701-1 provides that “the Internal Revenue Code prescribes the classification of various organizations for federal tax purposes. Whether an organization is an entity separate from its owners for federal tax purposes is a matter of federal tax law and does not depend on whether the organization is recognized as an entity under local law.” In general, Section 7701 and its regulations provide many entities with the choice of how to be taxed for U.S. purposes, i.e. as a corporation or as a flow-through entity.
“Per se” entities are described in Reg 301.7701-2.
A German Aktiengesellschast (AG) is a corporation with limited liability owned by shareholders holding shares that may be traded on a public stock market.
A German Gesellschaft mit beschrankter Haftung (GmbH) is a company owned by shareholders with limited liability.
In order to claim a qualifying foreign dividend, the U.S. must have a comprehensive treaty with the country where the foreign corporation is resident, the foreign corporation is eligible for treaty benefits under that treaty, and the IRS has determined that the treaty is satisfactory for purposes of the qualified dividend treatment. See Notice 2011-64, 2011-37 IRB 231.
Section 78 allows domestic corporations to “gross up” dividends received from a foreign corporation by an amount equal to the taxes deemed to be paid by the foreign corporation. The amount of the deemed taxes paid that is grossed up can be treated as foreign taxes paid for the domestic corporation’s foreign tax credit computation.
Section 482 provides that the “Secretary may distribute, apportion, or allocate gross income, deductions, credits, or allowances between…two or more organizations, trades, or businesses (whether or not incorporated, whether or not organized in the United States, and whether or not affiliated) owned or controlled directly or indirectly by the same interests…if he determines that such distribution, apportionment, or allocation is necessary in order to prevent evasion of taxes or clearly to reflect the income of any such organizations, trades, or businesses.”
The regulations connected with Section 482 are extensive and provide guidance on the methodologies that companies may use to document arm’s-length pricing.
Many countries outside the U.S. use the Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations prepared by the Organization for Economic Cooperation and Development. The guidelines are commonly referred to as “OECD Protocols.”
Section 6662(e)(3) provides that penalties for “net section 482 transfer pricing adjustment[s]” may be waived if “it is established that the taxpayer determined such price in accordance with a specific pricing method set forth in the regulations prescribed under IRC § 482 and that the taxpayer’s use of such method was reasonable, [and] the taxpayer has documentation (which was in existence as of the time of filing the return) which sets forth the determination of such price in accordance with such a method and which establishes that the use of such method was reasonable, and the taxpayer provides such documentation to the Secretary within 30 days of a request for such documentation.”
Competent authorities are employees designated by a country’s taxing authority to work on transfer pricing and other multinational treaty related issues.
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