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Chapter 8

International Taxation

Timothy Doupnik | Mark Finn Giorgio Gotti

© McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill
 Learning Objectives
• Describe differences in corporate income tax and withholding
tax regimes across countries.
• Explain how overlapping tax jurisdictions cause double taxation.
• Describe some of the benefits provided by tax treaties.
• Demonstrate how the participation exemption system and rules
related to controlled foreign corporations, Subpart F income,
and foreign tax credit baskets affect U.S. taxation of foreign
source income.
• Show how foreign tax credits reduce the incidence of double
taxation.
• Explain and demonstrate procedures for translating foreign
currency amounts for tax purposes.

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 Impact of Taxes–International Business
Decisions
Tax issues are important in deciding:
• Where to locate foreign operation.
• What legal form should foreign operation take.
• How the foreign operation will be financed.
Impact of taxes.
• International location decisions: based on forecasts of
after–tax profit and cash flows.
• Legal form of operation: branch or subsidiary.
• Method of financing:
• Capital contributions (equity) or debt.
• Repatriated back to parent: dividends, or interest.
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 Types of Taxes and Tax Rates
Types of taxes.
1. Corporate income taxes.
• Imposed by governments.
• Tax rates vary.
• Most between 15 and 35 percent.
• Sometimes both national and local taxing authorities.
• Could vary based on type of income earned.
• Average across countries declined from approximately 40 percent in 19 80 to
about 24 percent in 2021.
• Zero percent in some tax havens.

2. Withholding taxes.
• Taxes on dividends.
• Other amounts paid to foreign citizens and foreign parent companies.
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 Corporate Income Tax 1

Corporate income tax rates.

• Significant variation worldwide.
• Provides tax planning opportunity.
• Recently declining rates to be globally competitive.

Basis of taxability.
• Type of activity.
• Nationality of the company owners.

Variation in:
• Methods of calculating taxable income.
Differences in:
• Deductibility of expenses.
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 Corporate Income Tax 2

Tax Holidays.
• Low to zero taxes for a period of time.
• Encourage foreign direct investment.
• Usually have requirement regarding amount of investment and/or number of
jobs created.
Tax Havens.
• Abnormally low corporate income tax rates or no corporate income tax at all.
• Minimum worldwide income taxes.
• The Bahamas and the Isle of Man.
• No corporate income tax.
• Ireland and the Netherlands.
• The Netherlands has more foreign direct investment than the U.S.
• 376 of the Fortune 500 companies have at least one subsidiary in a tax
haven.
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 Withholding Taxes
Apply to:
• Dividends.
• Interest.
• Royalties.

Vary across countries.

• In some countries, varies by:
• Type of payment.
• Recipient.
• Differences in rates impact tax planning.

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 Tax–Planning Strategy
Altering the method of financing to reduce taxes.
• Thin capitalization: financing with debt instead of equity
when the dividend withholding rate is high.
• Interest payments are generally tax deductible but
dividend payments are not.
Several countries have limits on how much thin capitalization
is allowed.

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 Value–Added Tax
Substitute for sales taxes.
• Added into:
• Price of a product.
• Price of a service.
• At each stage of:
• Production.
• Distribution.
• In the EU, standard VAT rates range from 17 to 27 percent.
Used in the European Union, Australia, Canada, China,
Mexico, Nigeria, Turkey, Russia, Saudi Arabia, and South
Africa.
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 Tax Jurisdiction: Worldwide versus
Territorial Approach
Taxation approaches:
1. Worldwide (nationality) approach.
• Tax on all income of a resident or a company of a country.
• Regardless of place of earning.

2. Territorial approach.
• Tax only on income earned in that country.
Participation exemption system.
• Income of foreign branch of domestic firm is taxed.
• Income of foreign subsidiary of domestic firm is not taxed.
The United States:
• Prior to new tax law: income of foreign branch taxed immediately; income of
foreign subsidiary taxed when remitted back to parent.
• New tax law: participation exemption.

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 Tax Jurisdiction: Source, Citizenship, and
Residence 1

Basis for taxation:

• Source of income.
• Followed by almost all countries.
• Citizenship.
• Taxes citizens, regardless of source or residence.
• Used by the United States and very few other countries.
• Residence.
• Taxes residents, regardless of source or citizenship.

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 Tax Jurisdiction: Source, Citizenship, and
Residence 2

The basis of U.S. taxes:

• Source.
• Citizenship.
• Residence.
• Green card test.
The U.S. taxes foreign branches.
• Includes income in U.S. parent.
The U.S. does not tax foreign subsidiaries.
• Not considered a U.S. resident, so no U.S. tax.

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 Double Taxation
Same income is taxed in a foreign country and in the country
of residence.
• Normally, source takes precedence over residence so
parent company’s home country eliminates the tax.
Discourages foreign investment.
Capital-export neutrality: if a taxpayer’s decision on whether
to invest globally or locally is not impacted by taxation.

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 Relief from Double Taxation
Solutions:
1. Adoption of a territorial approach.
• Exemption of foreign source income.
2. Deduction of taxes.
• By parent company.
• Paid to the foreign government.
3. Foreign tax credit.
• To parent company.
• For taxes paid to the foreign government.
The U.S. allows:
• Deduction of taxes.
• Credit approach.
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 Tax Treaties: Model Tax Treaties 1

OECD Model.
• Assumes countries are economic equals.
• May be taxed by a partner country only if profits are attributable to a
permanent establishment.
• Can include an: office, branch, factory, construction site, mine, well, or
quarry.
• Does not include: Facilities used for the storage, display, or the delivery and
maintenance of goods.
• If there is no permanent establishment, then income is not taxable in that
country.
• Recommended withholding rates:
• 5% for dividends to corporation.
• 15% for portfolio dividends to individuals.
• 10% for interest.
• 0% for royalties.

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 Tax Treaties: Model Tax Treaties 2

United Nations Model.

• Designed for relationships between developed and
developing nations.
• The host country (the developing nation) should have more
taxing rights when profits are repatriated to the developed
nation.

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 U.S. Tax Treaties
Exempts interest and royalties from withholding tax.
15% maximum withholding rate on dividends.
• Not all U.S. treaties hold to this level.

The U.S. has treaties with more than 50 countries.

• Including treaties with all members of the EU.

Venezuela is the only South American country that the U.S.

has a treaty with.
• Most treaties would disadvantage those countries due to
the imbalance of foreign investment to them versus from
them.

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 Treaty Shopping
Resident of Country A uses a company located in Country B to
take advantage of Country B’s tax treaty with Country C.
• Brazil has no tax treaty with the U.S., so dividends from the U.S.
to Brazil are taxed at 30%.
• The U.S. has a treaty with Country C with a 10% withholding
rate.
• So Brazilian Company sets up a subsidiary in Country C, which
invests in the U.S. company.
• Thus, Brazilian Company gets 90% of dividend instead of just
70%.
• Sometimes there is a limitation of benefits if a significant
proportion of investment is held by third party taxpayers.
• Not applicable if the company is publicly traded.
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 OECD Base Erosion and Profit Shifting Action
Plan
Shifting profits to tax havens where no real economic activity
occurs is called base erosion and profit shifting (BEPS).
In 2013, the OECD developed a 15–item BEPS action plan.
• Designing effective controlled foreign corporation (CFC)
rules.
• Limiting base erosion via interest deduction.
• Mandatory disclosure of aggressive tax planning by MNCs.
• The design of domestic rules to prevent tax treaty abuse.

By May 2020, more than 90 countries had adopted the plan,

including many tax havens.
• The U.S. did not, due to existing treaties.
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 Controlled Foreign Corporations
CFC: any foreign corporation where U.S. shareholders own
more than 50% of the combined voting power or market
value of the stock.
No exemption for Subpart F income earned by a CFC.
• Thus, it is taxed in the U.S. immediately when earned by C
FC.

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 Subpart F Income
Four parts of Subpart F income:
1. Income derived from insurance of U.S. risks.
2. Income from countries engaged in international boycotts.
3. Certain illegal payments.
4. Foreign base company income:
1. Passive income: interest, dividends, royalties, rent, and
capital gains from sales of assets.
2. Sales income: CFC sales made outside of its country
of incorporation.
3. Service income: CFC performs services outside of its
country of incorporation.

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 Determination of the Amount of CFC Income
Currently Taxable
If Subpart F income is:
• Less than 5% of the CFC’s total income.
• No income taxable.
• Between 5% and 70% of the CFC’s total income.
• The proportion of Subpart F income to total income is
taxable.
• Greater than 70% of the CFC’s total income.
• 100% of the CFC’s income will be taxed currently.

Safe harbor rule: if the foreign tax rate is greater than 90% of
the U.S. tax rate, none of the CFC’s income is considered
Subpart F income.
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 Foreign Tax Credits
U.S. companies are allowed to either:
1. Deduct ALL foreign taxes paid on the related foreign
income, or.
2. Take a credit for foreign INCOME taxes paid on the
foreign income.
• Credit allowed for withholding tax on dividends.
• No credit allowed for sales, VAT, or excise tax.

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 Deduction for Foreign Taxes Paid versus
Foreign Tax Credit
Example: Assume ASD, a U.S. company, has a foreign
branch that earns income of $100,000 and paid foreign
income taxes of $15,000 (15%).
ASD also paid sales and other taxes of $10,000.

ASD Company’s U.S. Federal Income Tax Return

Deduction Credit
Foreign source income $100,000 $100,000
Deduction for all foreign taxes paid 25,000 0
U.S. taxable income $ 75,000 $100,000
U.S. income tax before credit (21%) $ 15,750 $ 21,000
Foreign tax credit (for income taxes paid) 0 15,000
Net U.S. tax liability $ 15,750 $ 6,000

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 Calculation of Foreign Tax Credit
Complex calculation in the U.S.
The FTC is the lower of:
1. The actual taxes paid to the foreign government, or.
2. The amount of taxes that would have been paid if the income had been
earned in the U.S.
Maximum FTC.
• Cannot be greater than the taxes that would have been paid in the U.S.
Foreign source taxable income
Overall FTC Limitation   U.S. taxes before FTC
Worldwide taxable income
Excess foreign tax credits:
1. Carried back 1 year.
2. Carried forward 10 years.
• Only used if foreign tax rate is lower than the U.S. tax rate in the future.

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 Calculation of Excess Foreign Tax Credit (One
Branch, Multiple Years)
• U.S. tax rate: 21%.
• Foreign tax rate: 20% in Year 1.
• Foreign tax rate: 23% in Years 2 and 3.
Year 1 Year 2 Year 3
Foreign source income $50,000 $70,000 $100,000
Foreign taxes paid $10,000 $16,100 $ 23,000
U.S. tax before FTC $10,500 $14,700 $ 21,000
FTC allowed in the United States 10,000 14,700 21,000
Net U.S. tax liability $ 500 $ 0 $ 0
Excess FTC $ 0 $ 1,400 $ 2,000

• In Year 2, file for a $500 FTC carryforward (refund).

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 FTC Baskets
Created by the Tax Reform Act of 1986.
Beginning in 2004, there were two FTC baskets:
1. General income.
2. Passive income.
• Reduced likelihood of excess FTCs going unused.
The TCJA of 2017 created a foreign branch income basket.
CANNOT MIX BETWEEN BASKETS.

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 U.S. Tax Treatment of Foreign Operation
Income 1

Must consider the following factors:

1. Legal form of the foreign operation (branch or
corporation).
2. Percentage level of ownership (CFC or not).
3. Effective foreign tax rate (“tax haven” or not).
4. Nature of the foreign source income (Subpart F?;
appropriate FTC basket?).

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 U.S. Tax Treatment of Foreign Operation
Income 2

General guidelines:
• Foreign branch: foreign pre–tax income included in U.S.
taxable income.
• Subsidiary:
• NOT a CFC: foreign income not taxable in the U.S.
• CFC: if foreign tax rate is 90% or more of U.S. rate,
foreign income not taxable in the U.S.
• CFC: if foreign tax rate is less than 90% of U.S. tax rate:
• Subpart F income:
• If less than 5% of total income: income not taxable in the U.S.

• If 5% to 70% total income: proportion taxable in the U.S.

• If greater than 70%, all foreign income immediately taxable in the U.S.

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 U.S. Tax Reform: Other International Tax
Provisions
Two objectives:
1. Make U.S. corporations more competitive internationally.
2. Prevent erosion of the U.S. tax base.

Most significant change: change from worldwide to

participation exemption system of taxation.
Other changes:
1. Deemed repatriation of accumulated foreign earnings.
2. Taxation of global intangible low–taxed income.
3. Imposition of a base erosion anti–abuse tax.

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 Deemed Repatriation of Accumulated Foreign
Earnings
On the 2017 tax return, U.S. corporations had to include foreign income
from 1987 to 2017 [equivalent to sending that foreign income to the U.S.
as dividend].
• Only taxed at 15.5% if held in cash.
• Only taxed at 8% if reinvested in property, plant, and equipment
instead of previous 35% rate.
• Can pay this extra tax in installments over eight years.
• Allowed foreign tax credit if dividend paid into U.S.
Global Intangible Low–Taxed Income (GILTI).
• Beginning in 2018, a U.S. corporation must include in taxable income
its GILTI based on two concepts:
1. Tested income
2. A specified return
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 Global Intangible Low–Taxed Income
• Tested income: the total amount of foreign subsidiary
income across countries, less certain deductions.
• Specified return: 10% of the book value of tangible
depreciable assets.
• The amount that tested income exceeds the specified
return is the amount of GILTI.

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 Example: Computation and Taxation of G ILTI

• Bogey Golf Corporation’s foreign subsidiaries had

$20,000,000 in property, plant, and equipment. They also
had an aggregate before–tax income of $5,000,000.

Tested income $5,000,000

Less: Specified return
QBAI Specified rate of return ($20,000,000 10%) 2,000,000
Excess (gross amount of GILTI) $3,000,000
Less: 50% reduction 1,500,000
GILTI included in U.S. parent’s taxable income $1,500,000

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 Base Erosion Anti–Abuse Tax
Base Erosion Anti–Abuse Tax (BEAT).
• Applies to companies that significantly reduce U.S. tax liability by making
payments to foreign affiliates.
• BEAT only applies to U.S. corporations that:

1. Are part of a group with average revenue of at least $500,000,000 over

the three previous years, and.
2. Have base erosion payments exceeding 3% of total deductible expenses;
includes royalties and rent, but NOT cost of goods sold.
• Determine if BEAT is owed by comparing:
• The actual taxable income against.
• 10% of company income when base erosion payments ARE NOT
deducted.
• If B > A, then the amount of B EAT owed is the difference between B and A.

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 Translation of Foreign Operation Income

Functional currency of foreign operation.

• If the U.S. dollar is functional, no need to translate since it is in
U.S. dollars already.
• If foreign currency is functional:
• Foreign operation net income is translated into U.S. dollars,
using the average exchange rate for the year.
• Grossed up by adding taxes paid to the foreign government
at spot rate when taxes were paid.
• When repatriated, the difference between the rate used as
income and the rate when repatriated creates a foreign
exchange gain or loss.
• The FTC is based on the exchange rate when taxes were
paid to the foreign government.
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 Example: Translation of Foreign Branch Income 1

Sabin Company has a foreign branch in Thailand. The Thai

Branch generates THB 5,000,000 pre–tax income. On
October 15, the branch sends THB 1,000,000 to Sabin
Company. The income tax rate in Thailand is 20%. Taxes
were paid to the Thailand government on December 31, Year
1.
US$ to THB
January 1 $0.040
October 15 $0.032
December 31 $0.030
Average for the year $0.035

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 Example: Translation of Foreign Branch Income 2

Pretax income THB 5,000,000

Taxes paid (20%) THB 1,000,000

Net income Average exchange rate THB 4,000,000 $0.035 = $140,000

Taxes paid Actual exchange rate THB 1,000,000 $0.030 = 30,000

Gain (loss) on October 15 repatriation THB 1,000,000 ($0.032 $0.035) = (3,000)

U.S. taxable income $167,000

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 Foreign Currency Transactions
In general, gains or losses arising from changes in exchange
rates are not taxed until realized (settlement date).
When hedge used, taxable amount is based on settlement
amount.
• Any gain/loss from foreign receivable/payable and forward
contracts are not recognized for taxes.

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