Chapter 10 FEDERAL TAXATION OF INTERNATIONAL TRANSACTIONS 1 Daniel Cassidy _________________________________________________________________ 10.1 INTRODUCTION Foreign companies with U.S. business transactions face various layers of taxation. These include income, sales, and excise taxes levied by all levels of government—federal, state and local. The purpose of this chapter is to provide an overview of U.S. federal income taxation as it applies to a foreign company’s investment and business transactions. We will not cover non- income taxes or taxes levied by state and local governments. Some of these issues are covered in other chapters of this book. For purposes of this discussion, we will assume that we are dealing with a corporation that is formed outside of the United States and is involved in business or investment activity in the United States. The rules for foreign individuals, estates, trusts, and non-corporate entities are similar to those discussed in this chapter. However, in the interest of keeping the discussion to a manageable size, we will not address these issues. 10.2 KEY CONCEPTS AND DEFINITIONS How business and investment income is taxed in the United States depends on who is earning the income, the nature of the income, and whether the transaction giving rise to the income is covered by a bilateral income tax treaty. This section will outline the general scheme of taxation in the United States as it relates to foreign corporations and will give an overview of certain definitions and key concepts. Later sections will explore specific types of transactions in greater detail. 10.2.1 General Scheme of Taxation The overall scheme of taxation of international transactions in the United States can be broken down into two categories: the taxation of U.S. persons and non-U.S. persons. In the context of corporate taxation, this distinction can be stated as the taxation of domestic corporations and foreign corporations. 1 Daniel Cassidy is a Certified Public Accountant and a Principal with Clark Nuber P.S. in Bellevue, Washington. 83 DOING BUSINESS IN WASHINGTON Domestic corporations are subject to U.S. taxation on their worldwide income—income from all sources, regardless of whether earned from activities in the United States or abroad. This income is subject to taxation on a net basis (gross income less expenses) at graduated corporate tax rates. Domestic corporations are also subject to a comprehensive anti-deferral regime that is designed to prevent taxpayers from sheltering income in offshore entities. Foreign corporations are not subject to this anti-deferral regime; however, U.S. subsidiaries of foreign corporations are subject to such provisions. Foreign corporations are subject to U.S. taxation on two broad classes of income: investment income from U.S. sources and income that is effectively connected to a U.S. trade or business. Investment income consists of interest, dividends, rents and royalties, and similar types of income from passive investments. This income is taxed on a gross basis at a flat rate of tax and is subject to source withholding. It also includes gains from the sale of assets that give rise to investment income. These gains are subject to U.S. tax to the extent that they are derived from U.S. sources. A foreign corporation’s business income is subject to tax in the United States to the extent that it is considered to be effectively connected to a U.S. trade or business. Income that is effectively connected to a U.S. trade or business is subject to net taxation at graduated tax rates—similar to U.S. corporations. Before we delve deeper into the details of U.S. taxation of international transactions, it is important to become familiar with important key concepts. These key concepts include the following: 1. Corporate residency: Domestic and foreign corporations; 2. Source of income: U.S. source income and foreign source income; 3. Type of income: Investment income and business income; and 4. Bilateral income tax treaties. 10.2.2 Corporate Residency A corporation’s residency can be broken down into two classes—domestic and foreign. A domestic corporation is any corporation that is created or organized under federal or state laws in the United States. A foreign corporation is any corporation that is not a domestic corporation. U.S. tax law determines residency of a corporation based on the jurisdiction of formation, but certain other countries determine residency based on where the corporation is managed or controlled. As a result, a corporation could be considered resident in two countries—raising the possibility of double taxation. Many income tax treaties resolve this problem. However, for transactions not covered by treaty, this situation can cause significant double taxation issues. 84 FEDERAL TAXATION OF INTERNATIONAL TRANSACTIONS 10.2.3 Source of Income U.S. tax law classifies all income into one of two categories—U.S. source and foreign source income. In general, a foreign company’s U.S. source income is subject to U.S. tax, while its foreign source income is exempt. The source of an item depends on the type of income. The following is a summary of how common types of income are classified. It should be noted that exceptions apply to these rules. 1. Interest and dividend income – Interest and dividend income are sourced based on the residence of the obligor. Interest or dividends paid by a domestic company are U.S. source income; interest and dividends paid by a foreign company are foreign source income. 2. Royalty income from the use of intangible property – Royalty income from the use of intangible property is sourced to the country where the intangible asset is located or used. 3. Rental income – Rental income associated with real or personal property is sourced to the country where the property is located. 4. Income from the provision of services – Income from the provision of services is sourced to the location where the services are provided. 5. Income from the sale of wholesale goods – Income from the sale of goods that are not manufactured by the seller are sourced to the location where the risks and benefits of ownership are transferred from the seller to the buyer. 6. Income from the sale of manufactured goods – Income from the sale of goods manufactured or produced by the seller are sourced fifty percent to the location where the goods are manufactured or produced and fifty percent to the location where the risks and benefits of ownership are transferred from the seller to the buyer. 7. Gains from the sale of corporate stocks and bonds – Gains from the sale of stocks and bonds are sourced to the residency of the seller. 8. Gains from the sale of real property – Gains from the sale of real property are sourced to the location of the property. 10.2.4 Types of Income A foreign company’s U.S. taxable income is broken into two types: investment income and income that is effectively connected with a trade or business in the United States (hereafter, “effectively connected income”). Investment income consists of interest, dividends, certain rents and royalties, and similar types of income from passive investments and is referred to as FDAP (FDAP is an acronym for “fixed or determinable annual or periodical gains, profits, and income.” The acronym FDAP will be used hereafter.) It also includes gains from the sale of assets that give rise to FDAP income or that give rise to no income. 85 DOING BUSINESS IN WASHINGTON A foreign corporation’s FDAP income is taxed in the U.S. to the extent it is derived from U.S. sources as determined under the source rules described above. Such income is taxed on a gross basis (no deductions or expenses are allowed) at a fixed tax rate. The statutory tax rate is 30 percent, but is often reduced under the provisions of applicable income tax treaties. Effectively connected income consists of business income related to U.S. activities. In order to have effectively connected income, a foreign company must first have a U.S. trade or business. Once it is established that a foreign company has a U.S. trade or business, its effectively connected income will consist of all U.S. source business income and certain foreign source income that is associated with the U.S. trade or business. A foreign corporation’s effectively connected income is taxed in a manner similar to a U.S. corporation. The tax is levied on net taxable income, which consists of gross income less allowable business deductions. The net taxable income is subject to graduated tax rates ranging from 15 to 35 percent. 10.2.5 Bilateral Income Tax Treaties Bilateral income tax treaties play an important role in the taxation of international transactions. They are designed to reduce the possibility of double taxation and allocate the right to tax international transactions between governments. Absent these treaties, the domestic laws of different countries could, and often would, lay claim to tax the same income. Tax treaties resolve this conflict, and in doing so, can override a country’s domestic law. Therefore, in order to understand U.S. taxation of international transactions we must look not only to U.S. law, but to the contents of its income tax treaties. Income tax treaties address a broad range of issues and each treaty has unique provisions. It is beyond the scope of this chapter to cover all of these issues. The discussion below is a summary of common treaty provisions affecting business investment in the United States. 1. Residency Tie-breaker Rules – The United States considers any corporation formed under its laws to be a U.S.