US TAXATION SYSTEM Omri Yaniv International Tax Manager, PwC US Taxation System - List of Topic Basis of taxation Taxation of foreign corporations .US domestic law .US tax treaties .Types of U.S. entities .Check the box regulations Foreign tax credit US Anti-deferral Provisions: .Subpart F Rules; .Passive Foreign Investment Corporation (PFIC) Rules Transfer Pricing 2 US Taxation System - General The US taxation system is primarily a personal based taxation system. US tax residents are taxed on their worldwide income Determination of residency (under domestic law) – .Corporation - a corporation is considered a US resident if incorporated in the United States .Individual – an individual is considered a US resident if he/she is either a US citizen or meets the (i) permanent residency status test; or (ii) the substantial presence test 3 Taxation of Foreign Corporations – US Domestic Law The United States generally asserts only a limited taxing jurisdiction over foreign residents (e.g., foreign corporations). ."Foreign corporation" – a corporation incorporated under the laws of a country other than the United States. A foreign corporation pays US tax only on income that has sufficient nexus with the United States. In order to examine whether there is sufficient nexus, three variables need to be examined: .The nature and source of the foreign corporation's income, i.e., whether derived from sources within the US or whether from sources without the US; .The nature of the foreign corporation's activities, i.e., whether engaged in a "US trade or business"; and .The relation between the income derived and the US activities , i.e., whether the income is "effectively connected" with a "US trade or business" 4 Taxation of Foreign Corporations – US Domestic Law Variable I – nature and source of the income Source Rules – rules for determining the source of income for US tax purposes. In determining the source of an item of income the specific sourcing rule that governs that certain type of income must be identified, e.g.: .Royalties - sourced in the place of use of the property for which the royalties are paid .Rental Income - sourced at the location or the place of use of the leased property for which the rental income is paid .Gains from the sale of personal property – generally sourced by reference to the seller’s country of residence (several exceptions exist) 5 Taxation of Foreign Corporations – US Domestic Law Variables II & III – nature of US activities and the relation between the income and the activities .Whether the foreign corporation is engaged in a US trade or business: – No definition of the phrase in the Internal Revenue Code (case-by-case resolution based the facts and circumstances). – Fundamental distinction – regular commercial activity versus passive investment. .If the answer is positive, what portion of the income is effectively connected with the conduct of such US trade or business: – The mere existence of a US trade or business is not sufficient to subject the investment income to the normal tax rates. – The existence of a trade or business in the US does not affect the taxation of unrelated investment income 6 Taxation of Foreign Corporations – US Domestic Law Income effectively connected with a US trade or Business If the foreign corporation (i) conducts a US trade or Business, and (ii) The income derived is effectively connected with such trade or business, then the income will be taxable inthe United States ona net basis. Income not from a US Trade or Business If the foreign corporation (i) does not conduct a US trade or Business, or (ii) does conduct a US trade or business but the examined income is not effectively connected with such trade or business, then the income will be taxable inthe US onlyif considered to be sourced within the US. 7 Taxation of Foreign Corporations – US Domestic Law The operative US taxation result is dependant upon the source determination: .Income Effectively Connected with a US Trade or Business: – Subject to the provisions of any applicable treaty, a foreign corporation generally pays US income tax at the regular US rates on net income. .Income not from a US Trade or Business: – A foreign corporation is generally subject to US tax at a flat rate of 30% with respect to US-source gross income, subject to the provisions of an applicable tax treaty which may reduce tax imposed by the United States. – Such tax is usually collected by way of withholding by the US-based payer, on amounts received from sources within the US by a foreign corporation. 8 Taxation of Foreign Corporations – US Domestic Law Source Determination - Examples category of income If income is If income is not effectively connected effectively connected 1. Capital gains Net income taxed at No US tax regular corporate rate 2. Fixed or determinable Net income taxed at Gross income taxed at income (e.g., interest, regular corporate rate flat 30% rate dividend, royalties) 3. US real property Net income taxed at treated as effectively interest gains regular corporate rate connected income 4. Other income Net income taxed at treated as effectively regular corporate rate connected income 9 Taxation of Foreign Corporations – Income Tax Treaties Treatment of Business Income - General In general, the US does not tax business income of a corporation that is resident in the country of a treaty partner unless the business income is attributable to a Permanent Establishment (“PE”) of the foreign corporation located within the United States. .It is possible for a foreign corporation to be engaged in a US trade or business but not to be operating through a PE in the United States. 10 Taxation of Foreign Corporations – Income Tax Treaties Treatment of Business Income - Definition of the term PE Any fixed place of business through which a resident of one of the Contracting States engages in industrial or commercial activity – three conditions: .The existence of a place of business – Facility or other premises or, in certain instances machinery or equipment – The place of business does not necessarily have to be owned or leased. – Examples – Office, branch, factory, place of management .The place of business must be fixed – Fixed place - link between the place of business and a specific geographical point. – Fixed period of time – not for a temporary period (permanency). – Established at a distinct place with a certain degree of permanence. .The business is carried on is conducted through the fixed place of business – the enterprise must carry on its business (wholly or partly) through the premises. – A PE may exist even if carried through automatic equipment (e.g., vending machine) 11 Taxation of Foreign Corporations – Income Tax Treaties Treatment of Business Income - Definition of the term PE Status of a person acting on behalf of a non-US resident corporation in the US: .A person with the authority to conclude contracts in the name of the non- US resident corporation within the US shall be deemed to constitute a PE in the US, unless: – Such person is an independent agent of such non-US corporation; – The relevant contracts relate to such matters that even if concluded through a fixed place of business would not make the fixed place of business a PE under the treaty (e.g., purchasing of goods). .The activity of a non-US resident corporation in the US which is conducted through a broker, general commission agent or any other agent of independent status in the ordinary course of their business will not constitute a PE in the United States. – The independence has to be from both a legal and an economical perspective. – Strict supervision on the agent's activity and guidance are indication of a dependant status. – Bearing of economical risks by the agent is indication of an independent status. 12 Taxation of Foreign Corporations – Income Tax Treaties Treatment of Other Income Treaties which the US is a party to may: .modify the US domestic source rules; .Modify the taxation rules by providing for reciprocal reduction of rates for investment type income; or .Exempt certain types of income. Examples from US/Israel treaty: .Dividend – reduction of withholding tax rate to 12.5% in case of a 10% or more corporate shareholder (from 30%) .Interest – reduction of withholding tax rate to 17.5% (from 30%); 10% in the case of financial institutions .Royalties – reduction of withholding tax rate to 10%/15% (from 30%) 13 Types of entities for U.S. tax purposes There are various types of entities for U.S. federal tax purposes, under two main categories: . Separate entities for tax purposes: – C-Corporation; .Flow-Through Entities: – Partnership (general or limited- LP); – S- Corporation; – Limited Liability Company (LLC); The law poses different requirements with respect to each type of entity (e.g., Restriction on type or number of members/ shareholders). 14 Types of entities for U.S. tax purposes Flow through entities are not taxed identically. Close analysis is required before deciding which entity to use for a specific activity. The tax treatment of the different flow through entities differs in many respects, such as: .Limitation on losses deductible by owners; .Highest tax rate; .Basis for allocating income to owners; .Non-liquidating distributions to owners; .Reporting requirements and tax computations. .Tax treatment of change in entity status (e.g., “S” election). 15 Types of entities for U.S. tax purposes Basic details in regard to the taxation of different types of U.S. entities: .Partnership and LLC – not subject to tax. Owners in their separate capacity subject to tax on their distributive share of income. Partnership must have at least two owners (LLC – in some states may be owned by single member). .S-Corporation – Not subject to Federal income tax (except for certain built-in gains and passive income when present from C-Corporation tax years); .C-Corporation – Income subject to two-tier Taxation (corporate and shareholder level).