Subject: International Taxation (subject code: 353915001)

Basic Introduction to US Income Taxation (Week 13)

December 9, 2014 International Taxation (Week 13)

Part I

Basic Concepts

2 International Taxation (Week 13) Sources of US Tax Law

• Federal Law US Internal Revenue Code US Treasury Regulations IRS Rulings and Interpretations Court Cases

• State Law

3 International Taxation (Week 13) Common Business Forms

C Corporation • C Corporation • Limited Liability Company (LLC) • Partnership

• S Corporation Partnership

S Corporation

4 International Taxation (Week 13) C Corporation

Share- Shareholder level tax holders

Corporate level tax: •Federal – 35% C Corporation •States – Vary (i.e., California = 8.84%, Delaware = 8.87%)

Tax return: •Consolidation allowed •Form 1120 •Due 3/15 with Extension 9/15

5 International Taxation (Week 13) Partnership

Partners • Partnership does not pay taxes • Income and losses flow to partners through Schedule K-1 • Tax Return:

Partnership − Form 1065 − Due 4/15 with Extension 9/15

6 International Taxation (Week 13) Limited Liability Company (LLC)

• If 100% owned by a single member  disregarded entity • If owned by 2 or more members  partnership • Can elect to be treated as a C Corporation (Check-the-box election)

2+ 1 Member Member(s) Members

LLC LLC LLC

7 International Taxation (Week 13) Entity Classification Election (Check-the-box)

• An entity that is not classified as a corporation under the “per se” rules can elect its classification for federal tax purposes • Eligible entities include: - LLC - Partnership - Any foreign entity that is not identified as a “per se” corporation (e.g., Taiwan -- 股份有限公司 vs. 有限公司) • Files Form 8832 to make the election - Not effective more than 75 days prior to the filing date - Not effective more than 12 months after filing date - 60-month limitation rule

8 International Taxation (Week 13) S Corporation

• Small Business Corporation • Taxed in a way similar to partnerships, income and expenses flow through to the owners/shareholders • Qualifications: - Only US citizens or residents can be shareholders - Only one class of stock (no preferred stock may be issued) - Limited to 100 shareholders - Only individuals, estates, certain trusts and certain charities may be shareholders (corporations cannot be shareholders)

9 International Taxation (Week 13) Computation of Taxable Income

+ Gross Income Inclusions

– Gross Income Exclusions

GROSS INCOME Book-to-tax adjustments – Items deductible for tax purposes (i.e., M-1 or M-3 )

+ Items not deductible for tax purposes

TAXABLE INCOME

10 International Taxation (Week 13) Statute of Limitation

• Generally − 3 years from later of due date or date of filing • Under-reported income > 25% − 6 years from later of due date or date of filing • Fraud − Unlimited statute of limitation • Refund claim − Later of 3 years from the time the return was filed

11 International Taxation (Week 13) Net Operating Loss (NOL)

General rule.— Except as otherwise provided in this paragraph, a net operating loss for any taxable year— 172(b)(1)(A)(i) shall be a net operating loss carryback to each of the 2 taxable years preceding the taxable year of such loss, and 172(b)(1)(A)(ii) shall be a net operating loss carryover to each of the 20 taxable years following the taxable year of the loss.

12 International Taxation (Week 13) Source of Income – General Rules

Personal Service Location of service performed

Sale of Inventory Buy and sell: title passage (e.g., FOB, CIF, DDU, DDP) Produce and sell: allocation (depending on the place of production) Interest Location of interest payer

Dividend Location of dividend payer

Rentals/Royalties Location where property is used

Real Property Sale Location of the real property

Personal Property Sale Seller’s tax home

13 International Taxation (Week 13)

Corporate Formation

14 International Taxation (Week 13) Section 351 Transaction

Individual Corp Transferor Transferor

Newco stock

Assets Assets NEWCO

15 15 International Taxation (Week 13) Section 351 -- Tax Free Contribution

- No gain or loss recognized by transferor shareholders upon: - Transfer of property - Solely in exchange for stock - Transferors control corporation (transferee) immediately after exchange - Mandatory tax-free treatment even if transferors want gain/loss recognition - Transferors can be individuals, corporations, partnerships, etc.

16 16 International Taxation (Week 13) Property

• Cash • Contract rights • Leasehold interests • Goodwill • Employment contracts • Know-how, patents • Services  not property

17 17 International Taxation (Week 13) Solely for Stock

• Common • Preferred • Voting • Nonvoting

But not Nonqualified Preferred Stock as defined in §351(g)

18 18 International Taxation (Week 13) Control

• 80% of total combined voting power of all voting classes, • AND • 80% of total number shares of each class of nonvoting stock • Attribution rules do not apply

19 19 International Taxation (Week 13)

Corporate Distribution & Redemption

20 International Taxation (Week 13) Earnings and Profits (E&P)

• History: - The phrase first appeared in the Revenue Act of 1916 - There is no comprehensive definition of the phrase - E&P is related to but different from book income and taxable income • Importance: - A distribution is a dividend to the extent of a corporation’s post-February 28, 1913 E&P

21 21 International Taxation (Week 13) Earnings and Profits (E&P) (con’t)

Common adjustments to taxable income to arrive at E&P: - Federal income taxes - Expenses associated with tax exempt income - Bribes, fines, and penalties - Meals and entertainment - Net premiums on officers’ life insurance - Expenses and losses between related parties

E&P focuses on a company’s ability to pay dividends

22 22 International Taxation (Week 13) Corporate Distributions

• Character of the distribution - Dividend (to the extent of E&P) - Return of capital (to the extent of basis in stock) - Capital gain

• Computation of current E&P - Computed as of the end of the taxable year

23 23 International Taxation (Week 13) Corporate Stock Redemptions

• Redemption – when shareholders sell his/her stock in a company to the company itself

• Sale vs. disguised dividends

24 24 International Taxation (Week 13) Corporate Stock Redemptions

- Some distributions from a corporation to its shareholders are not distributions of earnings and profits, but are in reality a sale or a reduction of the shareholder’s interest in the corporation

- Redemption rules (Section 302) determine whether distributions in redemption of stock should be characterized as sales or as dividend distribution

25 25 International Taxation (Week 13) Corporate Stock Redemptions

• - Redemptions are treated as a sale of stock if paragraph (1), (2), (3), or (4) of §302(b) applies (i.e., capital gain or loss to shareholder)

• - If a redemption fails to meet one of the §302(b) tests, the distribution is treated as a property distribution under §301 (a dividend to the extent of E&P) - §302(d)

26 26 International Taxation (Week 13) Redemption Tests

§ 302 (b)(1)—not essentially equivalent to a dividend • Some reduction in stock ownership • Not in control of the corporation after the transaction

27 International Taxation (Week 13) Redemption Tests (Cont’d)

§ 302 (b)(2)—substantially disproportionate redemption • 50% test—immediately after the redemption, the shareholder owns less than 50% of the voting stock, AND • 80% test—immediately after the redemption, the shareholder owns a percentage of stock which is less than 80% of his percentage of stock immediately before the redemption (based on both voting power and value)

28 International Taxation (Week 13) Redemption Tests (Cont’d)

• § 302 (b)(3) – termination of shareholders interest • Waiver of family attribution rule requirements 1. No interest retained in the corporation other than an interest as a creditor 2. No acquisition of prohibited interest within 10 years of redemption 3. Agree to notify IRS of acquisition of prohibited interest within the 10-year period

29 International Taxation (Week 13)

Corporate Liquidation

30 International Taxation (Week 13) Complete Liquidation

Shareholder

All Corporation stock Corporate assets and liabilities

Corporation

Cessation of Corporation’s Operations

31 International Taxation (Week 13) Complete Liquidations—§336

General Rules for Liquidating Corporation

• - Gain or loss recognized by a liquidating corporation on the distribution of property • - Property treated as sold at FMV • - Gain or loss computed asset by asset

32 International Taxation (Week 13) Complete Liquidations—§331

General Rules for Shareholders - Amounts received in complete liquidation of a corporation are treated as full payment in exchange for the shareholder’s stock - A shareholder’s amount realized is the FMV of the assets received less liabilities - A shareholder’s recognized gain is the amount realized less the shareholder’s basis in the stock

33 International Taxation (Week 13) Complete Liquidation of 80% or more owned Subsidiary

• Tax consequences to the liquidating corporation—§337 - - No gain or loss is recognized by the liquidating corporation on the distribution of property to the parent - - Non-recognition only applies to property actually distributed to the parent

34 International Taxation (Week 13) Complete Liquidation of 80% or more owned Subsidiary

Tax consequences to recipient parent corporation—§332

- Parent must meet the 80% stock ownership test: - Stock possessing at least 80% of all voting power, AND at least 80% of total value of all stock (the 80% control test must be satisfied from the date of adoption of the plan of liquidation until the final distribution) - Subsidiary must be solvent

35 International Taxation (Week 13)

Tax Free Reorganizations

36 International Taxation (Week 13) Acquisition Grid

Taxable Asset Taxable Stock Acquisitions Acquisitions

Tax-deferred Tax-deferred Asset Acquisitions Stock Acquisitions (Type A, C and D) (Type B)

37 International Taxation (Week 13) §368(a) – Reorganizations

A – Merger or consolidation B – Stock acquisition C – Asset acquisition D* – Asset transfer where target corporation controls acquiring corporation after reorganization (Acquisitive D) D* – Corporate Divisions E* – Recapitalization F* – Mere change of name, form or place of organization G* – Insolvency cases *- Not covered extensively in this course.

38 International Taxation (Week 13) Common Reorganization Requirements

• Plan of Reorganization

• Business Purpose

• Continuity of Interest

• Continuity of Business Enterprise

39 International Taxation (Week 13) Business Purposes

• Other than avoidance of tax

• Required even if there is no tax avoidance motive

40 International Taxation (Week 13) "A" Reorganization -- Statutory Merger

T S/H P S/H

P Stock T Stock

T Assets T Corp. P Corp. P Stock

41 International Taxation (Week 13) “B “ Reorganizations

- Acquisition by one corporation, in exchange for all or a part of its voting stock, of stock in another corporation, if immediately after the acquisition the acquiring corporation has control of the other corporation

- Voting stock of corporation in control of acquiring corporation may be used

42 International Taxation (Week 13) “B" Reorganizations

• Solely for voting stock requirement • - Can be either common or preferred • - Must be from one company (parent of acquiring or acquiring) • - Relative voting power of transferred stock is unimportant • - Cash in lieu of fractional shares ok • - No boot can be received

43 International Taxation (Week 13) "B" Reorganization Stock for Stock Exchange

80% of T Stock T S/H P Corp. P Voting Stock

T Corp.

44 International Taxation (Week 13) "C" Reorganizations

• - The acquisition by one corporation, in exchange for all or a part of its voting stock, of substantially all the properties of another corporation

• - Voting stock of corporation in control of acquiring corporation may be used

• - In determining if exchange is solely for stock, the assumption of Target’s liabilities is disregarded

45 International Taxation (Week 13) "C" Reorganizations

T S/H

P Voting T Stock Stock

P Voting Stock T Corp. * P Corp.

"Sub. all" T Assets * Note: Some exceptions to solely voting stock.

46 International Taxation (Week 13) “D" Reorganizations

• - A transfer by a corporation of all or part of its assets to another corporation, if immediately after the transfer the transferor (or its shareholders) are in control of the transferee corporation, but only if pursuant to the plan, stock or securities of the transferee corporation are distributed in a transaction qualifying under §354, §355, or §356 • - D reorganizations can be either integrating (acquisitive) or divisive. They must meet different control tests and other special rules.

47 International Taxation (Week 13) “E” Reorganizations

• - A recapitalization • - A change in the character and amount of outstanding capital stock or paid in capital

48 International Taxation (Week 13) “F” Reorganizations

• - A mere change in identity, form, or place of organization of a single corporation • - Change in name or change in state of incorporation • - Cannot be a change in assets or stockholders • - Merger into a new shell (no assets) can be an "F" reorganization

49 International Taxation (Week 13) “G” Reorganizations

• - Applies in Chapter 11 and similar cases • - Transfer of assets in exchange for stock or securities which are distributed

50 International Taxation (Week 13) §381 – Carryover of Tax Attributes

Tax attributes carry over to successor corporations in the following transactions: • “A” Reorganizations • “C” Reorganizations • Integrating “D” Reorganizations • “F” Reorganizations • Also applies in §332 liquidations

51 International Taxation (Week 13) §381 – Carryover of Tax Attributes

Attributes that carryover under §381 include: • NOL carryover • E&P • Capital loss carryover • Accounting methods • Inventory methods • Depreciation methods • Charitable contributions carryover • Credit carryover

52 International Taxation (Week 13) Sections 382 NOL Usage Limitation

• Limits the amount of taxable income against which pre- change NOL may be applied if a triggering event results in an ownership change of greater than 50 percentage points.

- Triggering event: Owner shifts or equity structure shifts (i.e. reorganizations) during the testing period (generally 3 years)

53 International Taxation (Week 13) Agenda – Part II

• US Inbound  Non-US person’s US income (ECI, FDAP, FIRPTA)  Withholding Tax  FATCA

• US Outbound  CFC  Subpart F  Foreign Tax Credit

54 International Taxation (Week 13)

US Inbound

55 International Taxation (Week 13) US taxes who and what?

US person Non-US person US source US source

US person Non-US person Non-US source Non-US source

56 International Taxation (Week 13) Taxation of Non-U.S. Persons

• A non-U.S. person generally is taxed in the United States only on its income derived from its U.S. investments or business activities. • The term “U.S. person” includes a U.S. citizen or resident alien individual, a domestic corporation, a domestic partnership, a domestic estate, or a domestic trust. §7701(a). - A “non-U.S. person” or a “foreign person” is any person other than a “U.S. person.” • A non-U.S. person generally is taxed in the United States only on income from U.S. sources.

57 International Taxation (Week 13) Sourcing Rules

• Interest and dividends generally are sourced based on the residence of the payer, with certain exceptions. • Rents are sourced based on where the subject property is located. • Royalties are sourced based on where the property is used or where the property is located, depending upon the type of royalty. • Income from the disposition of U.S. real property is U.S. source. • Compensation for labor or personal services performed in the United States is U.S.-source income.

58 International Taxation (Week 13) Non-US persons are generally taxed on…

Two major types of income:

• ECI • FDAP

59 International Taxation (Week 13) What is ECI?

• Effectively Connected Income (“ECI”)

ECI = “US trade or business” + Income arising from that trade or business

60 International Taxation (Week 13) U.S. Trade or Business

• A non-U.S. person who is engaged in an active trade or business in the United States and earns income from that business generally is taxed on its U.S.-source income that is considered “effectively connected” with that business. • Income that is effectively connected with the non-U.S. person’s U.S. trade or business is taxed on a net basis at graduated rates.

61 International Taxation (Week 13) U.S. Trade or Business

• The term “trade or business within the United States” is defined mainly by U.S. courts and the IRS. - It depends on facts and circumstances and is based on the nature and extent of the corporation’s economic activities in the United States, either directly or through its agents. - A trade or business must have a profit motive. - The IRS generally does not issue rulings with respect to what constitutes a U.S. trade or business.

62 International Taxation (Week 13) U.S. Trade or Business

• Activities generally must be “considerable, continuous, and regular.” • Ministerial, clerical, or collection-related activities generally are not sufficiently profit-oriented to constitute a U.S. trade or business. • Isolated activities generally do not rise to the level of a trade or business. • An agent’s activities in the United States may result in a U.S. trade of business. - Important considerations are whether the agent has the authority to conclude contracts in the United States, and whether the agent regularly exercises that authority in the United States.

63 International Taxation (Week 13) Trading Safe Harbor

• The “trading safe harbor” applies to a taxpayer trading in stocks or securities or commodities through a resident broker, commission agent, custodian, or other independent agent. • A taxpayer engaged in trading for his own account is entitled to the exception, as long as the taxpayer is not a dealer. - This is so, even if he conducts the trading through a resident agent or broker, etc., or whether the taxpayer has an office or other fixed place of business in the United States.

64 International Taxation (Week 13) Unlikely to be a U.S. Trade or Business

• Ministerial, clerical or collection-related activities • Investigatory activities/gathering market data • Purchasing of goods for resale abroad • Promotional activities, advertising • Unless the entire business purpose of the company is to carry out these functions

65 International Taxation (Week 13) Effectively Connected Income

• If a non-U.S. person has a U.S. trade or business, it is necessary to determine what income (if any) is effectively connected to such U.S. trade or business. - All U.S.-source active income a non-U.S. person earns is treated as effectively connected with that person’s U.S. trade or business. “Limited force of attraction” principle: › The U.S. trade or business “attracts” all of the foreign person’s U.S.-source income, but › The U.S. trade or business generally does not attract the non- U.S. person’s passive-type U.S.-source income. (See example on next slide)

66 International Taxation (Week 13) Limited Force of Attraction Principle

Facts • FC, a non-U.S. corporation, distributes cameras through a U.S. office. • The U.S. office and its activities constitute a U.S. trade or business. • FC also sells television sets (giving rise to U.S.-source income) directly to distributors without any involvement of its U.S. office.

Conclusion • FC’s income from both the camera sales and television sets is considered effectively connected with FC’s U.S. trade or business

67 International Taxation (Week 13) Effectively Connected Income

• Passive-type income and gain from the sale of capital assets are treated as effectively connected to a non-U.S. person’s U.S. trade or business only if the requisite connection with the U.S. trade or business exists. - Asset Use test: the passive-type income or capital gain is derived from assets used in the U.S. trade or business (§1.864-4(c)(2)). - Business Activities test: the activities conducted in the U.S. trade or business are a material factor in the production of the passive- type income or capital gain (§1.864-4(c)(3)).

68 International Taxation (Week 13) Effectively Connected Income

• Certain types of foreign-source income that have, in part, been generated through a U.S. office, can be effectively connected income (§864(c)(4)(B)). - Rents or royalties for use of property outside the United States that are derived in the active conduct of a U.S. trade or business. - Foreign-source dividends or interest derived in active conduct of banking business in the United States, or received by corporation the principal business of which is trading in stocks or securities for its own account. - Gain from the sale outside the United States of inventory property and property held for sale to customers, unless the property is sold for use outside the United States and a non-U.S. office materially participates in the sale.

69 International Taxation (Week 13) Effectively Connected Income

Form 1120-F • Non-US corporation required to report certain corporate information and certain worldwide financial information to the IRS • Opens a channel for the IRS to audit books and records • Relevant expense deductions allowed • Requirement to file Form 1120-F depends on whether foreign corporation has U.S. trade or business income, not whether it has taxable income • 35% tax rate plus 30% branch profits tax • If required to file but do not file, all expenses including COGS may be disallowed…this is huge! * Recent IRS audit example on a public Taiwan company 70 International Taxation (Week 13) Branch Profits Tax

• The branch profits tax imposes a 30% branch-level tax on a foreign corporation’s U.S. branch earnings and profits that are effectively connected with a U.S. business. • The 30% branch profits tax can be reduced or eliminated under treaty.

TW Co

Branch income: US 35% regular income tax Branch 30% branch profits tax

71 International Taxation (Week 13) US Sub vs. US fixed place of business or Branch

US Subsidiary US Branch

Taxable Income 100 100

Tax (40%) (40) (40)

Dividend 60* 60 Branch Profit W/H Tax (30%) (18) (18) Tax (30%)

42 42

* This dividend is not subject to withholding tax until it is distributed

72 International Taxation (Week 13) Permanent Establishment vs. US Trade or Business

• Where the foreign person is a tax resident of a jurisdiction with which the United States has an income tax treaty, the permanent establishment rules of the applicable treaty, rather than the U.S. trade or business rules, may apply. • The permanent establishment concept generally provides more certainty and a somewhat higher threshold than the U.S. trade or business rules.

Does Taiwan Co. have (PE, US trade or business) in the US?

73 International Taxation (Week 13) Foreign Investment in U.S. Real Property (“FIRPTA”)

• FIRPTA rules treat the gain or loss on the disposition of a U.S. real property interest (“USRPI”) by a foreign person: - as though the person were engaged in a trade or business within the United States, and - as if the gain or loss were effectively connected with the conduct of that trade or business. • Any gain is subject to U.S. income tax at graduated rates.

FIRPTA gain/loss = ECI

74 International Taxation (Week 13) FIRPTA

• USRPIs include: - Land and buildings, mines, wells or other natural deposits - Stock in a U.S. corporation (presumed to be USRPI)

75 International Taxation (Week 13) FIRPTA

• An interest in a U.S. corporation is a USRPI unless the corporation follows procedures in the regulations to prove it is not a U.S. real property holding corporation (“USRPHC”). - A USRPHC includes any corporation, U.S. or foreign, that has 50 percent or more of its assets in the form of USRPIs. - Any interest in a U.S. corporation, other than an interest solely as a creditor, is statutorily presumed to be a USRPI. ◦ Disposition is subject to U.S. tax and withholding unless it is established that the U.S. corporation has not been a USRPHC for a 5-year period ending on the date of disposition. › Exception – Stock of a U.S. corporation that is regularly traded on an established securities market.

76 International Taxation (Week 13) FIRPTA Notifications

• FIRPTA withholding is required at the time of a disposition, such as the transfer or sale of the shares of a U.S. company, even if it is not a USRPI. - Fulfill notice requirements certifying that the U.S. company is not a USRPHC (§1.897-2(g), §1.1445-2(c)). ◦ This must be initiated prior to the date of transfer. - Fulfill notice requirements certifying that the transferor is not required to recognize gain or loss by reason of a nonrecognition provision (§1.1445-2(d)). ◦ This must be initiated prior to the date of transfer. • Rev. Proc. 2008-27 provides a method to request relief for certain late filings.

77 International Taxation (Week 13) FIRPTA and your clients…

TW Co

US land, US Sub bdg, etc.

Think FIRPTA Think ECI Think US taxes and filing requirements

78 International Taxation (Week 13) Fixed Determinable Annual or Periodic (“FDAP”) Income

A non-U.S. person who does not operate a U.S. trade or business is taxed only on U.S.-source passive-type (FDAP) income. • Includes dividends, interest, rents, and royalties. • Taxed at a rate of 30% on a gross basis, with potential reduction or elimination under a U.S. income tax treaty

79 International Taxation (Week 13) Portfolio Interest Exception

• Allows non-US persons to invest in certain U.S.-issued debts without interest on such debts being subject to U.S. tax. • For debt issued before March 19, 2012, “portfolio interest” means any interest, including original issue discount, that would otherwise be subject to tax and that meets certain requirements for registered and non-registered debt. • For debt issued after March 18, 2012, interest on non-registered debt does not qualify for the exception.

Registered Debts

80 International Taxation (Week 13) Bank Deposit Exception

• §881(d) provides an exception from U.S. tax for interest on deposits, if such interest is not effectively connected with the conduct of a U.S. trade or business. • For this purpose, the term “deposits” means amounts that are: - Deposits with persons carrying on the banking business, - Deposits or withdrawable accounts with certain types of chartered and supervised institutions, and - Amounts held by an insurance company under an agreement to pay interest thereon.

81 International Taxation (Week 13) Withholding

• US withholding tax rate = 30% (can be reduced or eliminated under income tax treaty) • The withholding regime is generally designed to place the burden of collecting this U.S. tax on the person from whom the IRS can most readily collect such tax. • The 30% tax imposed on U.S. source FDAP income that is paid to a foreign payee is collected through withholding by the withholding agent. • Form W-8BEN

82 International Taxation (Week 13)

83 International Taxation (Week 13)

Summary 是否為美國來源所得 是 否 US Source Income

為外國來源所得(Foreign 為美國來源所得(US Source Income) Source Income)

該外國企業是否在美國 是否為〝與美國商業或 有或被認定為有〝固定 貿易有效的關連〞 營業場所〞 (Effectively connected (office or fixed place of with US trade or business) business)

否 是

是 否 不被認定為有與 即被認定為有〝與 美國商業或貿易 美國商業或貿易有 〝有效的關連〞 效的關連〞 外國公司必須在美 30%扣繳 國申報所得稅 (Form 1120F) 無須在美課稅 外國公司必須在美 國申報所得稅 (Form 1120F) 84 International Taxation (Week 13) Foreign Account Tax Compliance Act (“FATCA”)

• Due to increased U.S. scrutiny surrounding the perceived avoidance of U.S. taxation through the use of offshore bank accounts, on March 18, 2010, the FATCA provisions were enacted. • The provisions are generally effective for payments made on or after January 1, 2013. • FATCA generally imposes a 30% withholding on certain “witholdable payments” made to “foreign financial institutions” (“FFIs”) or “non- financial foreign entities” (“NFFEs”) unless certain requirements are met. • A withholdable payment is generally one comprised of U.S.-source FDAP plus original issue discount or gross proceeds from the sale of property that can produce U.S. source interest or dividends.

85 US Outbound

86 International Taxation (Week 13) Definitions and Foundational Concepts Introduction to Anti-Deferral

What is deferral? • Except in limited cases, foreign corporations are not subject to U.S. tax on foreign income, even if organized by a U.S. taxpayer - If earned directly, the U.S. taxpayer would be subject to tax on such income due to the U.S.’s system of worldwide taxation - However, under U.S. corporate tax rules, income earned by a corporation is generally not taxed in the hands of its shareholders until distributed to the shareholders • Taxpayers therefore could obtain “deferral” from paying U.S. tax on income earned abroad by forming a foreign corporation through which to earn such income. • This opportunity for deferral created an incentive for U.S. investors to invest in, and U.S. companies to operate through, foreign corporations organized in low- or no-tax jurisdictions. 87 International Taxation (Week 13) Definitions and Foundational Concepts When and how do subpart F rules apply? § 951(a) When a U.S. Shareholder owns stock in a foreign corporation on the last day of a taxable year where such foreign corporation qualified as a CFC for an uninterrupted period of at least 30 days during such year, the US U.S. Shareholder must include in income its pro rata share of Subpart F income even though there is no actual distributions from the CFC. Controlled Foreign Corporation (“CFC”) - § 957(a) A foreign corporation that is more than 50% owned by US Shareholders (by vote or value) U.S. Shareholder - § 951(b) A U.S. Person who owns, directly, indirectly, or constructively, 10% or more of the voting power of a foreign corporation.

88 International Taxation (Week 13) Definitions and Foundational Concepts

Example – Assuming A and B are not related, FC is not a CFC

C A B (non- (U.S.) (U.S.) U.S.) 45% 8% 47%

FC (Country X)

89 International Taxation (Week 13) Definitions and Foundational Concepts

Major categories of Subpart F income:

• Foreign Personal Holding Company Income (“FPHCI”) - § 954(c); • Foreign Base Company Sales Income (“FBCSI”) - § 954(d); • Foreign Base Company Services Income (“FBCSvI”) - § 954(e); and

90 International Taxation (Week 13) Foreign Personal Holding Company Income (FPHCI)

Generally includes passive types of income and gains from the sale or exchange of certain types of passively held property

• Dividends, interest, royalties, rents, and annuities • Gains from sale or exchange of property • Certain foreign currency gains

91 International Taxation (Week 13) Foreign Personal Holding Company Income (FPHCI)

Exceptions: There are a variety of exceptions to the definition of FPHCI. Broadly, these exceptions apply to income that results from the conduct of an active business. Exceptions with respect to related intercompany payments include: • Same country dividends/interest from related corporation • Same country rents/royalties from related corporation for use of property within CFC’s country • CFC look-through (until 12/31/2013 unless further extended)

92 International Taxation (Week 13) Foreign Personal Holding Company Income (FPHCI) Illustrations of FPHCI Exceptions US Corp

CFC 1 CFC 2 (Country A) (Country A) Same country exception

CFC 3 CFC look (Country B) through exception Carries on active business in Country B

93 International Taxation (Week 13) Foreign Base Company Sales Income

Section 954(d)(1) US Corp • FBCSI includes a CFC’s income (whether in the form of profits, commissions, fees, etc.) derived in connection with:  The purchase of personal property 2 from a related party (or on behalf of CFC A Sale of Product CFC B a related party); and/or (Country A) (Country B)  The sale of personal property to a 1 CFC A manufactures related party (or on behalf of a Product in related party). Country A 3 Sale of Product to … If the personal property was (a) Third Party Customers manufactured outside the CFC’s country located in Country C of incorporation, and (b) purchased or Third Party sold for use, disposition or consumption Customers outside of that country. (Country C)

94 International Taxation (Week 13) Foreign Base Company Sales Income

Manufacturing Exception:

• Same country manufacturing • Physical manufacturing

95 International Taxation (Week 13) Foreign Base Company Services Income

FBCSvI arises when income is derived from the performance of services by a CFC: • For or on behalf of a related person • Outside the country in which the CFC is organized. FBCSvI includes any compensation, commissions, fees, or other income derived from the performance of technical managerial, engineering, architectural, scientific, skilled, industrial, commercial, and similar services.

96 International Taxation (Week 13) Investment of Earnings in U.S. Property

Section 956 A U.S. Shareholder must include in income it’s pro rata share of the U.S. property held by the CFC as determined under section 956. • The rationale for requiring a U.S. Shareholder to include a pro rata share of the CFC’s increased investment in U.S. property is that the investment in U.S. Property represents a repatriation of the earnings of the CFC.

97 International Taxation (Week 13) Investment of Earnings in U.S. Property Which property is in the scope of 956(c)? • Sec. 956(c) defines “United States Property” to include any property acquired after December 31, 1962 which is— - Tangible property located in the United States; - Stock of a domestic corporation; - An obligation of a United States person (or under regulations a pledge or guarantee of such an obligation); or - Any right to the use in the United States of— ◦ A patent or copyright, ◦ An invention, model, or design (whether or not patented), ◦ A secret formula or process, or ◦ Any other similar property right which is acquired or developed by the CFC for use in the U.S. • Definition is not all-inclusive - e.g., it does not appear to include marketing intangibles

98 International Taxation (Week 13) Foreign Tax Credit - Requirements of a Creditable Tax

In general §901(b) allows a credit against U.S. income tax for “any income, war profits and excess profits tax paid or accrued...to any foreign country or to any possession of the United States” • §903 states that the term “income, war profits, and excess profits taxes” shall include a tax paid “ in lieu of ” an income tax

99 International Taxation (Week 13) Non-Creditable Foreign Taxes

• Non-income taxes (property taxes, excise taxes, VAT, etc.)

• Subsidies - Any benefit conferred, directly or indirectly, by the foreign country to the taxpayer - Reg. §1.901-2(e)(3)(ii)

• Taxes paid to “§901(j) countries” - Cuba, Iran, North Korea, etc.

100 International Taxation (Week 13) FTC Example (branch with direct tax)

US Corp • If a US corporation earns foreign income through a branch, the US corporation pays the foreign tax directly and receives a credit under Sec. 901 (i.e., a direct credit)

Foreign Income 1,000€ Foreign Tax $ 250 Foreign • US corporation will include Branch Assume $1 : 1€ $1,000 in gross income and claim a foreign tax credit of $250, subject to any limitation

101 International Taxation (Week 13) FTC Example (foreign subsidiary)

• If a US corporation earns foreign income through a sub and US Corp repatriates all the after-tax profits, the US corporation has not directly paid any foreign taxes and $750 thus can’t receive a Sec. 901 FTC Dividend • However, under §902, the US corporation will treat the $250 of Foreign Income 1,000€ taxes paid by the foreign sub as a Foreign Tax $ 250 Foreign FTC in the U.S. Foreign E&P 750€ Sub • US corporation will include the $1,000 in gross income ($750 Assume $1 : 1€ dividend plus $250 §78 gross-up) and claim a foreign tax credit of $250, subject to any limitation

102 International Taxation (Week 13) §902 Indirect Credit - Qualifications

• Only domestic corporations may claim a § 902 credit

• Domestic corporation must own 10% or more of voting stock of foreign corporation (on date the dividend is received)

103 International Taxation (Week 13) §902 Indirect Credit - Qualifications (cont’d)

• Ownership through a chain of foreign corporations - §902(b)(2)

- At least 10% direct ownership of voting stock at each level in chain - At least 5% indirect ownership of voting stock by US parent down chain - No more than 6 tiers removed from the US parent - 4th to 6th-tier foreign corporations must be CFCs

104 International Taxation (Week 13) Purpose of Sourcing Rules

Gross Income Deductions

Sourcing Rules Allocation & Apportionment

105 International Taxation (Week 13) FTC Formula

Foreign Foreign Source Tax = Taxable Income Credit Within Basket x US Tax Limit Total Taxable Income

106 International Taxation (Week 13) Passive Income Basket

• Passive income is any income that meets the definition of foreign personal holding company income - §954(c)

• Passive income generally includes: - Dividends - Interest - Rents - Royalties - Annuities - Gains from sale of property - Net commodities gains - Net foreign currency gains

107 International Taxation (Week 13) General Limitation Income Basket

• The general limitation basket is the residual basket for all other “unclassified” income

• General limitation income includes - Active trade or business income (high and low taxed) - Export financing interest - High-taxed passive income - Rents and royalties from an active trade or business

108 Thank you for your attendance.