Module 18Where to Do Business

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1. International tax treaties

2. Sources of income and allocation of deductions

3. Tax credits

4. Taxation of foreign corporations

5. Issues in multistate taxation

International Tax Treaties

Key Learning ObjectivesKey Learning Objectives Introduction to multinational taxationIntroduction to multinational taxation International tax treatiesInternational tax treaties Countries with which the U.S. has income Countries with which the U.S. has income

tax treatiestax treaties Model tax treatyModel tax treaty

International Tax Treaties

The United States is a party to tax treaties with over 40 countries

The basic goals of treaties are to Minimize the double taxation of incomeMinimize the double taxation of income

from international transactionsfrom international transactions Increase cooperation among tax Increase cooperation among tax

authoritiesauthorities

International Tax Treaties

Reduce the tax due to the country that is the source of income by Overriding the statute law of the source Overriding the statute law of the source

country country Providing tax reductions or exemptionsProviding tax reductions or exemptions

for certain types of transactionsfor certain types of transactions

Supreme Law of the Land

The Constitution The laws of the U.S. made under the

Constitution All treaties made or to be made under the

authority of the U.S.

Treaty or U.S. Tax Law?

Neither a treaty nor a law has preferential status by reason of its being a treaty or a law

When a revenue statute and a treaty provision conflict, generally the one adopted later controls

Sources of Income and Allocation of Deductions

Key Learning Objectives Sources of income Allocation of expenses and deductions Apportioning expenses to U.S. and foreign

source income Effect of tax treaties on source rules

U.S. Domestic Corporations andIndividuals Who Are

U.S. Citizens or Residents

Subject to U.S. taxation on their worldwide Subject to U.S. taxation on their worldwide incomesincomes

Foreign Corporations and Nonresident Alien Individuals

Subject to U.S. taxation on income fromSubject to U.S. taxation on income from Sources within the United States Sources within the United States Foreign sources if effectively connected Foreign sources if effectively connected

withwith a U.S. trade or business a U.S. trade or business

Allocation and Apportionment of Expenses

First allocate all deductions to specific classes First allocate all deductions to specific classes of income of income Reg § 1.861-8(a)(3) lists 15 classes of incomeReg § 1.861-8(a)(3) lists 15 classes of income

Then apportion the deductions to the U.S. and Then apportion the deductions to the U.S. and foreign source gross income within the classforeign source gross income within the class By comparison of the units sold, gross income, or By comparison of the units sold, gross income, or

other method that reflects the relationship between other method that reflects the relationship between the expense and the incomethe expense and the income

Tax Credits

Key Learning Objectives Tax credits Foreign tax credit or deduction Taxes that qualify for the foreign tax credit Separate limitations Claiming the credit Tax credit for income from U.S. possessions

Foreign Tax Credits FTC

May elect either to deduct foreign taxes orMay elect either to deduct foreign taxes or Use them as a credit against U.S. Tax Use them as a credit against U.S. Tax Can make or change the election any time Can make or change the election any time

before the expiration of the period for before the expiration of the period for claiming a refund for the taxable yearclaiming a refund for the taxable year

Foreign Tax Credits FTC

FTC is equal to the portion of U.S. tax FTC is equal to the portion of U.S. tax liability that results from inclusion of liability that results from inclusion of foreign source income foreign source income

Cannot exceed the amount of foreign taxes Cannot exceed the amount of foreign taxes paid or accrued during the year.paid or accrued during the year.

Taxes That Qualify for FTC

Imposed by foreign countries or U.S. Imposed by foreign countries or U.S. possessions on income, war , or excess possessions on income, war , or excess profits profits

Imposed in lieu of income taxes upon gross Imposed in lieu of income taxes upon gross income, gross sales, or units of production income, gross sales, or units of production If the predominant character is that of an If the predominant character is that of an

income taxincome tax ““Deemed paid” income taxesDeemed paid” income taxes

Taxation of Foreign Corporations

Key Learning Objectives Taxation of foreign corporations Controlled Foreign Corporations (CFC) Foreign Sales Corporations (FSC)

Foreign Corporation

Any association, joint stock company, or Any association, joint stock company, or insurance company that is insurance company that is Not organized in the U.S. Not organized in the U.S. Under laws of a state or District of ColumbiaUnder laws of a state or District of Columbia

Generally subject to U.S. Taxation only on Generally subject to U.S. Taxation only on their U.S. Source income that is their U.S. Source income that is Effectively connected with the conduct of a Effectively connected with the conduct of a

U.S. Trade or businessU.S. Trade or business

Controlled Foreign Corporation

> 50 % of the total voting power or total value of the stock is owned BY

U.S. shareholders on any day during the taxable year Stock can be owned directly or Stock can be owned directly or Indirectly through attributionIndirectly through attribution

Must be CFC for > 30 days in tax year before shareholder has problems

U.S. Shareholder of Foreign Corporation

May be taxed on foreign income before it is even distributed IF

Owns > 10 % the stock on the last day of taxable year OF

Corporation = CFC > 30 days in year AND Corporation has

Subpart F income Subpart F income OROR Increased E&P invested in U.S. propertyIncreased E&P invested in U.S. property

Foreign Sales Corporation FSC

Exempt from U.S. taxation on a portion of its foreign trade income

A U.S. corporation will: Organize a FSCOrganize a FSC Export its goods and servicesExport its goods and services

through the FSCthrough the FSC Reduce its income by paying the FSC aReduce its income by paying the FSC a

commission commission

Foreign Sales Corporation FSC

FSC distributes a dividend to the U.S. corporation

The U.S. corporation includes dividend in gross income BUT

Some or all of the dividend will qualify for the dividends received deduction

Issues in Multistate Taxation

Key Learning Objectives (1) Multistate taxation--an overview Due process and commerce clauses What constitutes nexus? Unitary principle

Multistate Taxation

All states impose state income taxes or value-added taxes on corporations Except Nevada, South Dakota, Washington, Except Nevada, South Dakota, Washington,

and Wyoming and Wyoming Many states also hold businesses

responsible for collecting and remitting the sales and use taxes imposed on the buyers of their products

Multistate TaxationRight to Tax

The state in which a business is organized can tax all income earned

Multistate TaxationRight to Tax

In order to tax income from interstate business

A state's system of taxation must satisfy

Two separate and independent clauses of the U.S. Constitution

The Due Process Clause

The Commerce Clause

Due Process Clause

Requires a minimum connection between A state and A state and The transaction, property, or party that it seeks The transaction, property, or party that it seeks

to tax. to tax. This connection is referred to as nexus.

Establish Nexus byMaintaining in the State

An office or other place of business Distribution facility, warehouse, or sales office,Distribution facility, warehouse, or sales office,

Inventory or other property A sample or display room in excess of two

weeks at any one location during the tax year

Establish Nexus byAdministrative Functions

Conducting training classes, seminars, or lectures Other than for personnel involved in Other than for personnel involved in

solicitationsolicitation Investigating credit worthiness Collecting current or delinquent accounts Repossessing property

Establish Nexus byProviding

Installation Repairs or maintenance Technical assistance or services

When one of the purposes is not the facilitation When one of the purposes is not the facilitation of the solicitation of ordersof the solicitation of orders

Commerce ClauseFour Requirements

There must be substantial nexus between the corporation and the taxing state

Tax must be fairly related to the benefits provided to the taxpayer by the state

The tax may not discriminate against interstate commerce

The tax must be fairly apportioned

Unitary Theory

In 1983 the Supreme Court held that states In 1983 the Supreme Court held that states can include the income of foreign can include the income of foreign subsidiaries in determining the tax liability subsidiaries in determining the tax liability

Most states that require combined Most states that require combined apportionment do not require income to be apportionment do not require income to be reported on a worldwide basisreported on a worldwide basis

Issues in Multistate Taxation

Key Learning Objectives (2) Allocation of income Apportionment of income Sales and use taxes

Non-Business Income

All income other than business income All income other than business income May include passive income May include passive income

Rents, royalties, interest, dividends, and certain Rents, royalties, interest, dividends, and certain capital gainscapital gains

Income is usually reduced by the expenses Income is usually reduced by the expenses incurred to earn itincurred to earn it

Allocation ofNon-Business Income

Usually allocated to Usually allocated to The state where the income-The state where the income-

producing producing property is locatedproperty is located OR OR To the state of commercial To the state of commercial domiciledomicile

The principal place from which the The principal place from which the corporation's business is managed or corporation's business is managed or directeddirected

Business Income

Income from transactions and activities in Income from transactions and activities in the regular course of the taxpayer's trade or the regular course of the taxpayer's trade or businessbusiness

Includes income from tangible and intangible Includes income from tangible and intangible property IF property IF

Acquisition, management, and Acquisition, management, and disposition of the property are integral disposition of the property are integral parts of the regular businessparts of the regular business

Apportionment of Business Income

Using a formula designed to measure the Using a formula designed to measure the proportion of business activity conducted in proportion of business activity conducted in each state each state

The most common apportionment method is the The most common apportionment method is the standard three-factor formulastandard three-factor formula Uses three equally weighted factorsUses three equally weighted factors

PropertyProperty PayrollPayroll SalesSales

ApportionmentThe Three Factor Formula (1)

First, determine these percentagesFirst, determine these percentagesProperty located in state Property located in state

Total propertyTotal property

Payroll located in state Payroll located in state

Total payrollTotal payroll

Sales located in state Sales located in state

Total salesTotal sales

ApportionmentThe Three Factor Formula (2)

Average the three percentages Average the three percentages Use average to apportion income to stateUse average to apportion income to state Note that income or loss that is allocable isNote that income or loss that is allocable is

Deducted from the corporation's net income Deducted from the corporation's net income Before the apportionment percentage is applied Before the apportionment percentage is applied

Sales Taxes

Imposed on the consumer of goodsImposed on the consumer of goods Some states also levy sales taxes on Some states also levy sales taxes on

services services Such as repairs and utilitiesSuch as repairs and utilities

Imposed only on sales where the seller and Imposed only on sales where the seller and the buyer are in the same statethe buyer are in the same state

Use Taxes

Charged when levying a sales tax is not Charged when levying a sales tax is not permissiblepermissible Vendor is out of state Vendor is out of state

Use taxes are assessed on the privilege of Use taxes are assessed on the privilege of owning or consuming tangible personal owning or consuming tangible personal property in a stateproperty in a state

Collecting Sales and Use Taxes

Responsibility is imposed on the vendorResponsibility is imposed on the vendor If a vendor fails to collect , the uncollected If a vendor fails to collect , the uncollected

tax becomes the vendor's liabilitytax becomes the vendor's liability

Nexus andSales and Use Taxes

Vendors that are engaged in interstate sales Vendors that are engaged in interstate sales are not required to collect sales taxes are not required to collect sales taxes UNLESSUNLESS

The vendor has sufficient nexus with the The vendor has sufficient nexus with the state in which the customer is locatedstate in which the customer is located Generally excludes catalogue sales if shipped Generally excludes catalogue sales if shipped

from out of statefrom out of state