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INTERNATIONAL TAXATION

Chapter 10

McGraw-Hill/Irwin

Copyright © 2009 by The McGraw-Hill Companies, Inc. All

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International Taxation
Chapter Topics







Taxes and international business decisions
Differences in national corporate tax and withholding tax regimes
Overlapping tax jurisdictions and double taxation
Foreign tax credits
Controlled foreign corporations, Subpart F income, and foreign tax
credit baskets
Tax treaties
Foreign currency translation for tax purposes
Tax incentives
10-2



International Taxation
Learning Objectives
1. Describe differences in corporate income tax and withholding tax
regimes across countries.
2. Explain how overlapping tax jurisdictions cause double taxation.
3. Show how foreign tax credits reduce the incidence of double
taxation.
4. Demonstrate how rules related to controlled foreign corporations,
subpart F income, and foreign tax credit baskets affect U.S.
taxation of foreign source income.

10-3

Explain and demonstrate procedures for translating foreign currency amounts for tax purposes. Describe tax incentives provided by countries to attract foreign direct investment and stimulate exports. Describe some of the benefits provided by tax treaties. International Taxation Learning Objectives 5. 6. 7. 10-4 .

debt or equity.  The decision about the legal form of the foreign operation.  Method of financing. is affected by the rules governing taxation of interest and dividends in the host country. The Impact of Taxes on Business Decisions International The location of international investments is affected by relative tax rates in the alternative countries. branch or a corporation. 10-5 . is dependent on differential tax treatments.

 These are imposed by most governments.  The tax rates vary from zero percent in tax havens to over forty percent. Learning Objective 1 10-6 . Corporate Income Tax and Withholding Tax Regimes Types of Taxes  Corporate income taxes are direct taxes on business income.  Another type of taxes are withholding taxes.  Withholding taxes are taxes on dividends and some other amounts paid to foreign citizens.

Learning Objective 1 10-7 . Corporate Income Tax and Withholding Tax Regimes Corporate income tax rates  Significant variation in tax rates worldwide provides a distinct tax planning opportunity.  Some countries tax at different rates based on the type of activity or nationality of the company owners.  Expenses that are deductible in one country are not deductible in others. there is also variation in how taxable income is computed.  In addition to variation in tax rates.

there has been a worldwide trend toward reduced tax rates. Corporate Income Tax and Withholding Tax Regimes Corporate income tax rates  Since the mid 1980s.  Tax haven countries take this trend to the extreme with some of these jurisdictions having zero percent tax rates.S. started this trend with many other countries following suit in order to be competitive in attracting foreign investments. Learning Objective 1 10-8 .  The Organization for Economic Cooperation and Development (OECD) has established guidelines to mitigate the negative impact of tax havens.  The U.

 Heavy debt financing is referred to as thin capitalization. Learning Objective 1 10-9 . and royalties.  Variation in withholding rates impact on tax planning. withholding taxes vary across countries and by type of payment and recipient.  Similar to corporate income taxes.  For example. interest. Corporate Income Tax and Withholding Tax Regimes Withholding taxes  These taxes typically apply to three types of payments: dividends. a higher tax rate on dividends than interest payments would encourage relatively more debt financing and less equity financing.

and South Africa. Hungary. Nigeria.  It is also used in Australia.  These taxes are added into the price of the product or service at each stage. but it is common in the the EU. Turkey. Learning Objective 1 10-10 . China.S. Mexico. Corporate Income Tax and Withholding Tax Regimes Value-added tax  A substitute for sales taxes. Canada. does not have value-added tax.  The U.

and can even result in triple taxation. this is referred to as double taxation. Tax Jurisdiction and Double Taxation Double taxation  When two countries tax the same income.  Overlapping jurisdictions give rise to double taxation. Learning Objective 2 10-11 . and the same company’s home government taxes its foreign source income.  This occurs when one country taxes the income earned by a foreign company in that country.

regardless of where it is earned.  Territorial approach – only income earned in that country is taxed. Learning Objective 2 10-12 .  The worldwide approach is much more common. Tax Jurisdiction and Double Taxation Taxation approaches  Worldwide (nationality) approach – all income of a resident or company of a country is taxed by that country.

 Almost all countries tax income earned within their borders--that is.  The citizenship basis taxes income of the country’s citizens regardless of source or where they reside. Learning Objective 2 10-13 . citizenship. and residence. at its source. Tax Jurisdiction and Double Taxation Basis for taxation  The three most common bases for taxation are source.  The residence basis taxes income of the country’s residents regardless of source or citizenship.

 Residence is also defined by residing in the U. taxes on the basis of source. Tax Jurisdiction and Double Taxation Basis for taxation – The U. this means that a U.  In combination with the worldwide approach. and residence. approach  The U.  Residence is defined by being a permanent resident (green card test).S.S. Learning Objective 2 10-14 . permanent resident that does not live in the U.S. is taxed on their foreign source income.S. citizenship. for at least 183 days in a year (physical presence test).S.

 In other words. Learning Objective 3 10-15 . source takes precedence over residence. Foreign Tax Credit (FTC) Background – Causes of double taxation  Double taxation usually arises when a company is taxed on income earned in a foreign country and taxed on that same income by its country of residence.  To alleviate double taxation in these cases. the country of residence generally defers to the country where the income was earned.

including the U. use the deduction and credit approaches.S.  A third solution is for a country to provide a tax credit to domestic companies for taxes paid to foreign governments.  Most countries..  Another solution is for a country to allow domestic companies to deduct taxes paid to foreign governments. exempting foreign source income from taxation. Learning Objective 3 10-16 . Foreign Tax Credit (FTC) Background – Solutions to double taxation  One solution is for a country to adopt the territorial approach.

 Given that the majority of such taxes are income taxes.S.  The other is to receive a tax credit for all foreign income taxes paid. approach  The Internal Revenue Service (IRS) allows companies one of two options. Foreign Tax Credit (FTC) FTC – The U. Learning Objective 3 10-17 . companies tend to take the tax credit.  One is to deduct all foreign taxes paid.

 The U.  GCO pays $16.000.S.S.500 of corporate income tax in Mexico and $20.  GCO decides to do a calculation to choose between using taxes paid in Mexico as a deduction or tax credit. corporate income tax rate is 35%. Foreign Tax Credit (FTC) FTC – Example  Assume that GCO is a U. company which has a branch in Mexico where the corporate income tax rate is 33%. Learning Objective 3 10-18 .  GCO has foreign source income in Mexico of $50.000 of other taxes.

000 $36.500 $13.725 $ 0 $ 4.000 $17.500 $ 1. tax liability Learning Objective 3 Deduction $50.000 10-19 .000 $ 0 $50. Foreign Tax Credit (FTC) FTC – Example Foreign source income Deduction for all taxes paid U.S.500 $ 4.S.S.725 Credit $50. taxable income U.500 $16. income before tax credit Foreign tax credit Net U.

S. will not allow the credit to exceed the FTC limitation.  Excess FTC can be carried back one year or carried forward ten years. OR the taxes that would have been paid if the income was earned in the U.S. Foreign Tax Credit (FTC) FTC – Other  The U.  This limitation cannot exceed either actual taxes paid to a foreign government. Learning Objective 3 10-20 .

which reduced the likelihood that excess FTC’s would go unused:  General income  Passive income Learning Objective 3 10-21 . FTC from different baskets could not be netted against one another. FTC was calculated separately for each of the nine baskets. Foreign Tax Credit (FTC) FTC baskets      The Tax Reform Act of 1986 created nine FTC baskets. These baskets were defined by different types of foreign income. The American Jobs Creation Act of 2004 reduced the number of baskets to two.

 Foreign Tax Credit (FTC) FTC baskets under TRA 86          Passive income High withholding tax interest Financial services income Shipping and aircraft income Dividends of domestic international sales corporations (DISCs) Foreign trade income of a foreign sales corporation (FSC) Dividends from an FSC Foreign oil and extraction income All other income Learning Objective 3 10-22 .

allows an indirect FTC on foreign taxes paid by a foreign subsidiary of a U.S.S.  This FTC is not allowed until the income of the subsidiary is taxed in the U.  The amount of income of a foreign subsidiary that is taxable in the U. Learning Objective 3 10-23 . parent. is the before tax or “grossed-up” dividend.S. Foreign Tax Credit (FTC) Indirect FTC (for subsidiaries)  The U.S.S. the U. parent must own at least 10 percent of the voting stock of the foreign subsidiary.  To qualify.

 Unlike the deferral of tax on foreign subsidiaries until receipt of a dividend.  There is a safe harbor for such income in jurisdictions with tax rate > 90% of the U. Controlled Foreign Corporations. and FTC Controlled foreign corporation (CFC) Baskets A foreign corporation where U.S.S. Learning Objective 4 10-24 . Subpart F income is taxable currently. taxpayer that owns at least 10 percent of the stock. Subpart F Income. shareholder is a U.  Much CFC income is referred to as Subpart F income.S. rate. shareholders own more than 50 percent of the combined voting power or fair value of the stock  A U.S.

 Controlled Foreign Corporations. Learning Objective 4 10-25 . Subpart F Income. and FTC Summary of foreign source income taxation Baskets What is the legal form of the foreign operation?  Is the operation a CFC?  Is the operation located in a tax haven?  Does the income qualify as Subpart F income?  The answers to each of these questions affects the determination of how foreign source income is taxed.

 Their purpose is to alleviate double taxation problems. Tax Treaties  Tax treaties – bilateral agreements regarding how individuals from one country are taxed on income earned in the other country.  Reducing double taxation helps facilitate international trade and investment.  Tax treaties also involve information sharing between governments that helps in domestic enforcement. Learning Objective 5 10-26 .

 Recommending withholding tax rates is another key part of the OECD model. Tax Treaties Model treaties  The OECD model treaty is the basis for most bilateral treaties of developed countries. Learning Objective 5 10-27 .  A key part of the OECD model is that host countries only tax business profits of foreign companies associated with permanent establishments.  The United Nations model treaty is designed to serve as a basis for treaties between developed and developing nations.

Learning Objective 5 10-28 .  The U.S.S. primarily due to lack of Brazilian investment in the U.  This model has zero percent withholding tax for interest and royalties and 15 percent for dividend payments. has treaties with over 50 countries. also has a model tax treaty that serves as a starting point when negotiating tax treaties. tax treaties  The U. Tax Treaties U.S. that some countries are trying to stop.S. related to treaties.  One notable exception is Brazil.  Treaty shopping is a tax reduction tactic.

 Taxes paid to the foreign government.”  When earnings are repatriated to the U.S. Translation of Foreign Operation Income in a Foreign Currency Translation of foreign branch income  Net income is translated into U. translated at the exchange rate on the payment date.  This second step is referred to as “grossing up. and converted to U. dollars. dollars at the average exchange rate for the year.S. the difference between this amount and the translated net income is a taxable foreign exchange gain or loss. are then added. Learning Objective 6 10-29 .S.

S.”  The translated amount of taxes deemed paid is used to determine the foreign tax credit. parent are translated at the spot rate on the date of payment. translated at the spot rate on the date of payment. Learning Objective 6 10-30 . are then added.  Taxes deemed paid on the dividend. or “grossed up. Translation of Foreign Operation Income in a Foreign Currency Translation of foreign subsidiary income  Dividends paid to the U.

 Many Asian countries offer tax holidays to foreign companies. Learning Objective 7 10-31 . Tax Incentives Tax holidays  The term tax holiday refers to an incentive used by a government that partially or completely exempts a taxpayer for a period of time.  The primary reason for offering tax holidays is to encourage foreign direct investment.  MNEs can enjoy significant tax reductions provided that profits are not repatriated.

 The Extraterritorial Income Exclusion Act (ETI) essentially replaced the FSC. companies.S.S. Tax Incentives U.  Domestic international sales corporation (DISC) was a short-lived export incentive program for U. Learning Objective 7 10-32 .  Both of these programs were eventually repealed due to foreign opposition.  Foreign sales corporation (FSC) was another short-lived export incentive program for U.S. companies. export incentives  CFC and Subpart F income provisions prevent some tax avoidance strategies previously used by exporters.

 In addition.S. manufacturing sector.  The deduction is available even to companies that don’t export. Tax Incentives American Jobs Creation Act of 2004 (AJCA)  The AJCA was an attempt to spur job growth in the U. Learning Objective 7 10-33 . the AJCA contains a provision that allows for significant tax breaks on repatriations of foreign source income.  The program provides a deduction that effectively reduces income tax rates for domestic manufacturers. broadly defined.