Tax Planning/Tax Opinions Articles – International Taxation2020-04-03T12:38:15-07:00
Tax Planning/Tax Opinions Articles – International Taxation
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International Taxation (13)

Two Tests

If you are an alien (not a U.S. citizen), you are considered a nonresident alien unless you meet one of two tests. You are a resident alien of the United States for tax purposes if you meet either (1) the green card test or (2)the substantial presence test for the calendar year (January 1-December 31).

Certain rules exist for determining the Residency Starting and Ending Dates for aliens.

Elections

In some cases aliens are allowed to make elections which override the green card test and the substantial presence test, as follows:

  • Nonresident Spouse Treated as a Resident
  • Closer Connection To a Foreign Country
  • Tax Treaties

Dual Status

You can be both a nonresident alien and a resident alien during the same tax year. This usually occurs in the year you arrive or depart from the United States. If so, you may elect to be treated as a Dual Status Alien for this taxable year and a Resident Alien for the next taxable year if you meet certain tests.

Tax Treaties

A resident alien who is required to establish his/her U.S. residency for the purpose of claiming a tax treaty benefit with a foreign country should refer to Certification of U.S. Residency for Tax Treaty Purposes.

Residency

Two Different Tax Regimes: US persons and Non-US persons

U.S. persons are taxed on their Worldwide Income (Income from US and Foreign sources). They are entitled to a Foreign Tax Credit to the extent of their Foreign Source Income.

Foreign person are mostly taxed only on their U.S. source income.

Because of this distinction, we need to ask two questions whenever dealing with any International Tax issue:

1 – What is the residence of the taxpayer?

2 – What is the source of the income?

In week 1 we will focus on answering Question 1

In week 2 we will focus on answering Question 2

RESIDENCY

The most useful approach is to determine if a person or entity is a U.S. person, if not, you can assume they are a non-US person.

An individual can obtain US person status if ANY of the following 4 methods applies:

Citizenship ? Person is a US citizen

Legal Residency ? Person holds a Green Card

Permanent Resident under Substantial Presence Test 1 (SPT 1)

Permanent Resident under Substantial Presence Test 2 (SPT 2)

Substantial Presence Tests

SPT1: If a person is present in the US for 183 days or more in a given year, they are a US person. This is an objective test because you are jus counting the days.

SPT 2: This test is met if the following elements are met:

1 – a person is present in the US for 31 days or more in a current year AND

2 – they are present in the US for 183 days or more over the last 3 years using a weighed systems AND

3- they do not have a Closer Connection to a Foreign Tax Home in the current year, then they are a U.S. person.

Note that SPT2 contains objective elements (1 & 2) and a subjective element (3). All of them must be met for SPT2 to apply. Let?s look at them in more detail.

Element 1 is straight forward: count the days they are in the US in the current year, if it?s less than 31 days then SPT2 will not apply.

Element 2 is tricky. You need to count all the days the person was in the US over the last three years. Let?s say they are contemplating their tax position for 2004. You must look at the days they were in the US for 2004, 2003 and 2002. The days in 2004 will count as one full day. The days in 2003 will count as 1/3 of a day and the days in 2002 will count as 1/6 of a day. Add them up using this weighted measure, if it is 183 or more you can go to Element 3.

Element 3 is a subjective element. You first have to determine if they have a Foreign Tax Home. To determine if they have a Foreign Tax Home you must ask the question ?what is their home for purposes of taking travel expense deductions?? Then you have to determine if they have a Closer Connection to that Foreign Tax Home. This is a subjective test where you look at a number of variables: where they are employed, where their family lives, where they belong to clubs, etc? There is no right or wrong answer, it is an issue of fact.

Days that don?t count in the calculation: For purposes of SPT1 and SPT2 you do not include certain days in your calculation, these exempted days apply for days for commuting, medical emergencies, charitable sports events, teachers, and students.

Corporations: The residence of a corporation is based on where it is incorporated.

Some countries define residence based on central place of management. So It is possible to have a dual-resident corporation.

For further clarification I will elaborate on the following two areas:

The difference between the tax regime for U.S. persons and non-U.S. persons, and

The exceptions to the Substantial Presence Test.

The difference between the tax regime for U.S. persons and non-U.S. persons

Let?s assume that a Taxpayer, T, earned $500 in 2004 with $100 of expenses. His tax calculation would be as follows:

Gross Income: $500

Expenses: ($100)

Taxable Income: $400

Tax Rate 35%

Tax Liability $140

Now let?s assume that of the $500 of income, $200 was from services performed in the U.S. (US source income) and $300 was from services performed in France (foreign source income). Also assume that a French tax of 30% was imposed on the $300.

If T is a non-U.S. person (i.e. not a US citizen, green card holder and fails both Substantial Presence Tests), then his tax calculation would be as follows:

Gross Income: $200 (foreign source income is not taxable)

Expenses: ($100)

Taxable Income: $100

Tax Rate: 35%

Tax Liability: $35

If T is a U.S. person, then his tax calculation would be as follows:

Gross Income: $500 (Worldwide income is subject to US tax)

Expenses: ($100)

Taxable Income: $400

Tax Rate: 35%

Tax Liability: $140

Foreign Tax Credit: ($90) 30% French tax on the $300 French income

Tax Due: $50

As you can see, for a Non-US person foreign source income is not even included in the tax calculation. For a US person, the foreign source income is included in Gross Income. However, the US person may get a Foreign Tax Credit for taxes paid on foreign source income.

There are exceptions, but this is the general framework of the two different tax regimes. We will be exploring both of these in greater detail as the course develops. Starting next week, we will only be looking at Non-US persons and how they are taxed on their US activities (referred to as Inbound Transactions). After the midterm we will focus on US person and how they are taxed in the US on their foreign activities (referred to as Outbound Transactions).

The exceptions to the Substantial Presence Test

Generally, when performing the Substantial Presence Test calculation you count every day that the Taxpayer was present in the US. However, the following days are not included in the SPT calculation even though the Taxpayer was physically present in the US:

Commuters from Canada & Mexico: If a person returns home at least once during each 24 hour period they are not considered to have spent a day in the US for SPT purposes.

Short stopovers: Presence in the US while in transit between two points outside the US does not count as a day spent a day in the US for SPT purposes. This is relevant if an Irish person, for instance, was in the US 182 days in a given a year and she also spent 1 day at Miami International Airport on a layover to Brazil. That extra day won?t put her over the 183 day threshold. However, if she conducts a business meeting at the Miami airport, then that day would count.

Medical emergencies: If a person is unable to leave the US because of a medical emergency, those days are not counted for SPT purposes. However, if the taxpayer came to the US with the intent of pursuing a medical treatment, those days would count for SPT purposes.

Teachers, trainees and students: Teachers and trainees who are in the U.S. for the purpose of teaching with a J visa are not required to count their days in the US for SPT purposes. Students are also exempt if they are in the US with a F, J or M visa.

Diplomats, employees of international organizations and their families.

Participants in charitable sports events.

Crew members of foreign vessels.

With all areas we will be discussing, it is most important to remember the general rule. Exceptions rarely apply, however it is important to know they exist and run a check just in case.

Question No. 1

W and H, wife and husband, are citizens of Canada. They do not have U.S. citizenship nor do they hold a U.S. green card. They maintain homes in both Quebec and Florida. W and the couple?s minor children spend about nine months each year at the Florida home, and the children attend school in Florida public schools. W and the children spend the summer months (80 days) in Quebec. H, who owns a construction company in Quebec, spends most of the year in Quebec, but makes several trips to Florida each year, aggregating 70 days annually. H?s income comes from the construction business. W owns several farms in Quebec which are rented to tenants and produce a significant amount of rental income. H & W do not file a joint return in the U.S.

How are H and W taxed by the U.S.?

W is present in the U.S. for about 285 days (in Canada for 80 days). This is sufficient for W to be a resident under SPT1 since she is present in the US for more than 183 days.

H?s presence in the U.S. does not meet the thresholds of SPT1 or SPT2:

Current year: 70 X 1 = 70 days

Prior year: 70 X 1/3 = 23.3

Two years prior: 70 X 1/6 = 11.6

Total days in the US using the weighted method: 105 days which is less than the 183 day threshold.

How does the analysis of H?s situation change if he stays in the U.S. a total of 125 days annually.

Now H would be the threshold of SPT2:

Current year: 125 X 1 = 125 days

Prior year: 125 X 1/3 = 41.6

Two years prior: 125 X 1/6 = 20.8

Total days in the US using the weighted method: 187.5 days which is more than the 183 day threshold.

In order for H to be a US person under SPT 2, he must also satisfy the subjective element of the test (i.e. closer connection to a foreign tax home). Since this is a subjective test and you only have limited facts to work with your answer could go either way.

Question No. 2

Nelson is a citizen of Brazil. He has a full-time job in that country and generally lives there with his family in a home he has owned for over 20 years. In 2015, Nelson comes to the United States for the first time. The sole purpose of the trip is business. Nelson intends to stay in the U.S. for only 180 days, but he runs into problems with his business and is required to stay 300 days.

In 2016, Nelson comes to the U.S. again on business and stays for 90 days. He returns to Brazil as planned.

Early in 2017, Nelson comes to the United States on business and stays for 170 days. Later in 2017, he returns to the U.S. to take his 6 year old son to Disney World for 10 days and then return to Brazil. On the last day of the planned visit, Nelson breaks his leg in an automobile accident. He is checked into the hospital for treatment, where he remains for five days. Nelson and his son leave the U.S. as soon as possible after he is released from the hospital.

Under these facts, discuss Nelson?s residence status in the U.S. in 2015, 2016 and 2017.

2015

Nelson is a US person for 2015:

He is present in the US for 300 which meets SPT1 (note that his intention to stay less is irrelevant)

2016

Nelson is probably not a US person for 2016 despite the fact that he satisfies the first two elements of SPT2.

2016: 90 X 1 = 90 days in the US

2015: 300 X 1/3 = 100 days in the US

Total days in the US: 190 days, which is greater than the 183 day threshold. However, Nelson can make a reasonable argument that he has a closer connection to a foreign tax home since he has many associations with Brazil. Since he does not meet the subjective element of SPT2, he would not be a US person for 2016.

2017

Nelson is probably not a US person for 2017

2017: 180 days (don?t count the 5 days he is in the US for the medical emergency).

2016: 90 X 1/3 = 30 days

2015: 300 X 1/6 = 50 days

Total days in the US: 260 days. However, since he probably has a closer connection to a foreign tax home, he does not meet the subjective element of SPT2 and he would not be a US person for 2017.

Controlled Foreign Corporations

Now we are going to switch focus from the tax consequences for non-US persons to the tax consequences for US persons. As we discussed at the beginning of the course, US persons are taxed on their worldwide income. Their ultimate tax liability may be reduced by a foreign tax credit but all income, US source and foreign source, is included in the US taxpayer’s gross income. We will discuss the application of the Foreign Tax Credit in more detail in 2 weeks. First we will look at Anti-Deferral Legislation.

Purpose of the Controlled Foreign Corporation / Subpart F Rules

Consider the following two scenarios:

Scenario 1

Ted, a US individual, has a portfolio of foreign stocks that pay annual dividend payments of $100,000. Although the income is foreign source income (since a foreign corporation is making the distributions) Ted must include the full amount in his US gross income. If no foreign tax was imposed on the dividend income, Ted would not be entitled to a foreign tax credit.

Scenario 2

Ted creates a newly formed corporation in Bermuda, BerCo, and transfers his portfolio of foreign stocks to BerCo. Now the only asset that Ted owns is stock in BerCo. When BerCo earns the $100,000 dividend payments, it will not be subject to US tax because BerCo is a non-US person (it is incorporated outside the US) and non-US persons with no US trade/business are not subject to US tax on foreign source income. Meanwhile, Ted is also not subject to US tax since he did not receive any payments. Only when BerCo makes a dividend payment to Ted will he be subject to tax. Hence, Ted was able to defer US tax on the foreign stock dividends indefinitely. Meanwhile, BerCo can reinvest the dividend proceeds and grow the portfolio offshore without being affected by US tax.

You should note how easily it was for Ted to make the switch from Scenario 1 to Scenario 2. All he had to do was file some paperwork (incorporate BerCo and transfer his shares to BerCo) and his tax consequences were drastically altered.

Consider another similar strategy for abuse:

Scenario 1

USCo has an export business in which it purchases baseball caps in the US for $500,000 and sells them to retailers in Japan for $600,000, resulting in a gain of $100,000. USCo also has a branch in Japan that negotiates and concludes the sales. Title transfers in Japan making the gain from the sales foreign source. Nonetheless, USCo is subject to US tax on the $100,000 even though it’s foreign source income because USCo is a US person.

Scenario 2

USCo creates a newly formed corporation in Bermuda, BerCo, and sells the baseball caps to BerCo for a small but reasonable mark-up of $40,000. BerCo resells the baseball caps to the Japanese retailers for $600,000. In this scenario, USCo only has $40,000 of gain and the remaining $60,000 of gain is earned by BerCo. Since BerCo is not a US person the $60,000 would not be subject to US tax until it is distributed to USCo as a dividend. USCo was able to defer US tax on the income indefinitely while BerCo reinvests the sales proceeds offshore without being affected by US tax.

As in the earlier example, the shift from Scenario 1 to Scenario 2 merely requires some paperwork: incorporating BerCo and drafting sales agreements between USCo and BerCo and another agreement between BerCo and the Japanese retailers. Other than the documentation no real changes have occurred. USCo may still ship the baseball caps directly to Japan and all sales activities continue to be performed in Japan. The employment contracts of the sales force in Japan may be redrafted so that BerCo is their employer instead of USCo. Basically, the form of the transaction has been changed but the underlying substance of the transaction remains unchanged.

The Controlled Foreign Corporation (CFC) and Subpart F legislation was enacted in order to control these abuses. The intent of the legislation is to prevent US persons from accumulating wealth in low-tax jurisdictions. However, they also did not want to cause US corporations to be less competitive abroad. So when you have a foreign corporation with US shareholders you must ask two questions: 1) Is the foreign corporation controlled by US shareholders (is it a CFC)?; and, if so 2) Is the income earned by Foreign Corporation tainted income (does it earn Subpart F income)? Tainted income (commonly referred to as Subpart F income) is income that was shifted to the Foreign Corporation strictly for tax reasons and not really for business reasons.

Consequences of a CFC with Subpart F Income

Assume you have a Foreign Corporation that is a CFC (which we will define later) and that CFC earns $1000 of Subpart F income (which we will define next week) and $2000 of non-Subpart F income. The consequence is that the US shareholders of the CFC must include the $1000 of Subpart F income in their Gross Income in the year it was earned by the Foreign Corporation. The $2000 of non-Subpart F income does not need to be included in the US shareholder’s Gross Income until such time that the Foreign Corporation distributes the income. Basically, if a CFC earns Subpart F income you treat it as if the CFC distributed that income to the US shareholder in the year it was earned by the CFC.

When a real distribution of the $1000 of Subpart F income is made to the US Shareholders, you ignore the transaction and there is no need to include it in the US Shareholders’ Gross Income again since it was already included earlier.

What is a CFC?

A CFC is a Foreign Corporation that is controlled by US Shareholders. First we must define a “US shareholder.” There are two criteria that must be met for a taxpayer to be a US shareholder: 1) The taxpayer must be a US person (as defined by the residence rules), and 2) The taxpayer must own 10% or more of the Foreign Corporation. So if you have a Foreign Corporation where no single shareholder owns more than 9.99% of the stock, none of the shareholders would be “US shareholders” and as a result the corporation could not be a CFC.

Under the pre-2017 law you only looked to the percentage of voting shares that the shareholder owned to determine if the 10% threshold was met. Under the post-2017 law you can also be a US shareholder by owning 10% of the value of the corporation regardless of ownership of voting shares.

Once you have identified all the US shareholders of a Foreign Corporation, you must add up all of their shares and determine if together they own MORE than 50% of the Foreign Corporation’s stock. So if you have 5 US persons that each own 10% of the stock of a Foreign Corporation and the remaining 50% is owned by Foreign persons, you do not have a CFC, because only 50% (not more than 50%) is owned by US persons.

Direct Ownership, Indirect Ownership & Constructive Ownership

When we calculate the number of shares that a US shareholder owns there are three forms of ownership that we look at, direct, indirect and constructive ownership.

Direct Ownership

Direct Ownership is straight forward, if a US shareholder owns shares in her name then she owns those shares directly.

Indirect Ownership

If a US shareholder owns shares in a Foreign Corporation (FC1) that owns shares in a Foreign Subsidiary (FC2), then the US shareholder owns shares in FC2 indirectly. So if T, a US shareholder, owns 20% of FC1 and FC1 owns 50% of FC2, then T owns 20% of FC1 directly and 10% of FC2 indirectly.

Note that indirect ownership can only occur through Foreign Corporations. If FC1 was a US corporation, there would be no indirect ownership of FC2.

Constructive Ownership

Constructive Ownership is ownership through family members or related entities (such as parent corporations and their subsidiaries). Assume that a Foreign Corporation has 100 shares, 9 shares are owned by H, a US person, 9 other shares are owned by W, H’s wife who is also a US person, 33 shares are owned by X, an unrelated US person and the remaining 49 shares are owned by a foreign shareholder. If we just rely on Direct Ownership, W and H are not US shareholders since they both hold less than 10% of the Foreign Corporation. As a result we only have one US shareholder (X) and he owns less than the requisite “more than 50%” threshold. However, spouses are required to attribute their shares to each other. So for purposes of determining whether or not a person is a US shareholder, we include their shares and shares of closely related family members. So H is deemed to own 18% of the shares (making him a US shareholder) and W is deemed to own 18% of the shares (making her a US shareholder). So now we have three US shareholders H, W, X. If we add up their shares (9+9+33 = 51), it exceeds the “more than 50% threshold” and the Foreign Corporation is a CFC.

Note that Constructive ownership is only used to determine whether or not a person is a US shareholder. It is not used to determine how much Subpart F they must include in Gross Income. For instance, assume that the Foreign Corporation in the above example earned $5000 of Subpart F income. H would include $450 (9%) in his Gross Income, not $900 (18%). The same would be true for W. X would include $1,650 (33%).

The close family members that attribute shares to each other are the following:

Spouses attribute shares to each other

Siblings DO NOT attribute shares to each other

Parents attribute their shares to their Children and Children attribute their shares to their Parents

Grandchildren attribute their shares to Grandparents but Grandparents do not attribute their shares to Grandchildren (this is a tricky one)

So if you had the following family that owned the following number of shares, here’s how it would break down:

X Corp. has 100 shares outstanding owned by:

Actual Constructive Total

Ownership Ownership Ownership

Husband 10 40 (Wife and Child) 50

Wife 20 60 (Husband, Child and Father) 80

Child 20 30 (Husband and Wife) 50

Wife’s Father 30 60 (Wife, Wife’s Sister, Child) 90

Wife’s Sister 20 30 (Father) 50

Note that a Non-US person can never attribute shares to a US person. So if a US person is married to a Non-US person, they do not constructively own each other’s shares.

To sum up, in order to identify US shareholders we consider Direct, Indirect and Constructive ownership. However, in order to determine the amount of Subpart F inclusion, we only consider Direct and Indirect ownership.

Now that we’re able to identify whether a Foreign corporation is a CFC or not, next week we will learn to determine if the CFC earns Subpart F income.

Expatriates & Sourcing
Expatriates

The tax code provides an exemption for expatriates to encourage US employees to work abroad and to ease the complications of being taxed in two jurisdictions. The first step is to determine if a US person qualifies as an expatriate. The second step is to determine how much they can exempt.

Step 1:

A U.S. person is an expatriate if they have a tax home in a foreign country. The concept of ?tax home? was introduced in the discussion on Residency. If a person takes travel deductions when traveling away from their home in France, for instance, then you can conclude that their ?tax home? is in France.

In addition to having a foreign ?tax home?, a US person must ALSO meet one of the following requirements to be considered an expatriate. The US person must

– Spend 330 days of the year abroad, OR

– Be a Bona Fide resident of a foreign country (this is a subjective test where you look at intentions, activities, physical presence?)

Step 2:

Once we?ve determined that the taxpayer is an expatriate, we have to determine what exclusions are available to them. There are two exclusions available:

1/ Foreign Earned Income Exclusion (FEI): $102,100 of wages, salaries, fees…for services performed in foreign countries (it will be $104,100 in 2018).

– Where the services are performed is what matters, not where the income is paid to.

– The exemption only applies to Personal Services. Not gain on sale of property (unless property was created by taxpayer ? art, royalties for writer).

2/ Foreign Housing Expenses (FH):

Applies to a reimbursement or stipend provided by the employer.

– Includes rent, fair rental value provided by employer, utilities repair, parking, insurance on property.

– Not included: purchase of house, capital improvements, mortgage, property tax. Furniture.

Excludes housing expenses to the extent they exceed 16% of the FEI exclusion, or $16,336. The theory here is that $16,336 is the amount that the average worker in the US would spend on housing. Anything above that is the additional cost the employee had to incur for working abroad, and therefore exempted to create a level playing field between US workers abroad and US workers in the US.

Example 1:

Jones has lived and worked in Peru from 2/1/15 to 12/31/15. He received a salary of $102,100 and housing cost reimbursements of $21,336.

He can take FEI exemption for the full $102,100 and a $5,000 FH exemption ($21,336 – $16,336).

Example 2:

Same as above but Jones? housing cost reimbursement is $40,336.

He can take a $102,100 FEI exemption, and a FH exemption of only $14,294. The maximum amount of the FH exemption is $14,294 ((30% x $102,100) ? $16,336). Even though his housing cost exceeds $16,336 by $24,000, only $14,294 is eligible for the FH exemption due to the 30% cap.

If Jones was living and working in Germany instead of Peru, he may be able to take a FH exemption of the full amount, because the 30% cap does not apply in high cost countries such as those in Europe or Japan.

Law Changes

Note that the addition of the 30% cap is fairly recent. Prior to 2006, there was no such limitation so long as the housing costs were reasonable.

There has also been a law change in 2006 regarding the tax rate that applies to the income that exceeds the FEI exemption amount.

Prior to 2006, if an expatriate worker earned $107,100, the excess amount over the FEI exemption of $5000 ($107,100 – $102,100) would be subject to the tax bracket of someone making $5000 which is 10%, resulting in a tax liability of $500 (10% of $5000). Under the new law, the tax bracket would be the same as someone earning $107,100, which is 28%, resulting in a tax liability of $1400 (28% of $5000).

Note that the amount that exceeds the FEI exemption may still be offset by a foreign tax credit. Typically, if the tax rates of the foreign country are higher than the US tax rates, the foreign tax credit would eliminate US tax liability. We will be discussing the details of the foreign tax credit later in the class.

Sources of Income

Relevance

Now that we?ve determined the residence of the taxpayer, the next step is to establish whether the taxpayer?s income is US source or Foreign source.

The source of income is important for Foreign Residents because, for the most part, Foreign Residents are not subject to US tax on Foreign Source income (there are some exceptions that we?ll get into later).

Although US persons are subject to US tax on Worldwide income (i.e. both US and Foreign Source income), the source of income is still important since the amount of Foreign Tax Credit available to US persons will be based on the amount of the taxpayer?s Foreign Source income.

Methodology

The way to approach a Source analysis is to take the following three step approach:

1- Identify the type of income: Interest, Dividend, Royalty, Compensation for Services, Gain from the Sale of Property, Inventory Gain)

2- Identify the General Rule for sourcing the income: For example, for Interest Income the general rule is that the income is sourced according to the residence of the debtor. For Income Compensating Services the general rule is that the income is sourced according to the location where the service was performed.

3- Determine if any of the Exceptions apply. For every rule there is usually an exception. For example, the General Rule for Interest Income is that the income is sourced according to the residence of the debtor (the party who is paying the interest). So if you have a US corporation paying interest to the Taxpayer, under the General Rule the Income would be US source. However, if more than 80% of the US corporation?s income is from ?active foreign business income? then the interest income is Foreign source.

Assignment 2 will require you to make an outline using this methodology. This will serve as a valuable tool for the exams and for professional uses. It will also allow me to assess how well you understand the Sourcing rules.

A note on sourcing income from the Sale of Property

The General Rule for Gain from the sale of property is that it is sourced according to the Residence of the Seller. So if the taxpayer is a US resident, her gain from the sale of a car would be US source income.

Here?s the tricky part: So far we?ve determined that the residence of a taxpayer is determine by using one of the following tests: Citizenship, Legal Residency (green card), SBT1 and SBT2. However, for the purposes of determining source of gain from the sale of property, there is a different definition of residence. Here, Residence is determined based on the ?Tax Home? of the taxpayer. So if Tom, a US citizen, has a home and operates a business in Hungary, Tom would be a US person under the General Residence rules. However, if Tom sold his car and realized gain of $1000, that income would be Foreign source income because his Tax Home is not in the US.

A note on sourcing income from the Sale of Inventory

The general sourcing rule for gain from the sale of property does not apply for inventory (i.e. goods that are held for resale).

Inventory is sourced based on where title (ownership) is transferred). To determine where title is transferred you must look at where risk of loss is transferred.

For example: Assume a contract specifies that a US Seller sells bicycles to a German Buyer and the German buyer will receive title when the goods arrive in Germany. However, the contract also specifies that the goods are transferred F.O.B. Long Beach (free-on-board Long Beach, means that if anything happens to the goods after they leave the port of Long Beach, the Seller is not responsible for any risk of loss). Hence, if the boat carrying the bicycles sinks, the German Buyer would still have to pay for them. Although the FORM of the contract stated that ownership was transferred in Germany, the SUBSTANCE of the agreement implies that ownership is really transferred in the US. The source of the gain is therefore US source. This is an example of the doctrine of Substance over Form.

A note on sourcing income from the Sale of Manufactured Inventory

Although gain from the sale of inventory is sourced according to where title is transferred, gain from the sale of inventory that is manufactured in the US will be sourced in the US. So if title is transferred outside the US but the goods are manufactured in the US, the gain is sourced in the US. Likewise, gain from the sale of inventory that is manufactured outside the US will be foreign source income.

This is a new rule as a result of the Tax Cuts and Jobs Act of 2017. For years prior to 2018, the gain in such situations would be divided into foreign source and US source income according to one of the following methods (the taxpayer was able to choose among the three methods):

50/50 Method: 50% of the gain is sourced in the US and 50% of the gain is sourced outside the US.

Independent Factory Price Method (IFP): Requires sales to independent distributors.

Books and Records Method: the gain is sourced based on how it is recorded in the taxpayer?s Books and Records (this method requires approval from the IRS).
A note on Interest Expense

Prior to 2018, the taxpayer could choose to allocate interest expense based on basis of assets or based on the Fair Market Value (FMV) of assets. This is covered in the reading on the second paragraph of page 67.

Under the Tax Cuts and Jobs Act of 2017, only allocation can only be made according to the basis of the assets and not the FMV.

I will elaborate on the following areas:

Difference between a Corporation and a Branch
Exceptions to the General Rule for Sourcing Interest and
Exceptions to the General Rule for Sourcing Dividends.

The Distinction between a Corporation and a Branch

A Corporation is a distinct legal entity. It must satisfy specific requirements in order to be recognized as an organization that is independent from its shareholders. So when a Corporation enters into contracts or takes on a loan, it is on its behalf and not on behalf of its shareholders, directors or employees.

If a US Corporation (USCo) has a subsidiary in Korea (KorCo), it means that we have two distinct legal entities that act on their own behalf. USCo owns all of KorCo’s shares but when KorCo is independent of USCo. If USCo is to buy goods from KorCo it would have to enter into an agreement with KorCo. USCo would be a US resident because it is incorporation in the US and KorCo would be a non-US resident because it is incorporated outside the US.

A Branch is not a distinct legal entity. There are no formal legal requirements to create and maintain a branch. For instance, if USCo sent some employees to start a sales office in Korea (but did not formally incorporate that office), then USCo would have a Korean branch. If employees in the Korean branch obtained a loan or entered into a contract, they would be doing so on behalf on USCo since the branch is not a separate entity. Consequently, interest payments made by the Korean branch would be US source to the party receiving the interest.

The distinction between a Corporation and a Branch may be rudimentary to some students in this class. However, it is a distinction that everyone should understand since the differing treatment of Corporations and Branches arises in many areas of international tax.

Exceptions to the General Rule for Sourcing Interest

The General Rule for sourcing interest payments is to base it on the residence of the payor. So if a foreign corporation (ForCo) makes a loan to a US corporation (USCo) and USCo makes interest payments on that loan, then that interest is US source income.

Remember from the Residence rules that a corporation is sourced based on where it is incorporated. So when a US corporation is making interest payments, that interest is US source.

Exception No. 1: Foreign Branch of a US bank

As we just saw, the payment of interest by a foreign Branch of a US Corporation will be US source income. However, there is an exception for US banks with foreign branches. In order to encourage the competitiveness of US banks abroad, interest payments by foreign branches of US banks are foreign source income. If a Korea resident made a deposit with the foreign branch of Wells Fargo Bank, the interest received on that deposit would not be US source income and not subject to the 30% tax. Note that most US banks incorporate their foreign branches so this exception is rarely applied.

Exception No. 2: 80/20 Rule

If a US Corporation (USCo) performs 80% or more of its activities outside the US, then ALL interest paid by the USCo would be foreign source income even though USCo is a US resident. So regardless of whether USCo performs 85% or 99% of its activities abroad, 100% of its interest payments will be foreign source. However, if USCo pays the interest to a “related person”, it is necessary to apportion the sourcing of interest according to the percentage of foreign activities. A “related person” is one that owns 10% or more of the interest payor.

Assume that all of USCo’s shares are owned by a Korean corporation (KorCo) and KorCo makes a $100,000 loan to USCo with interest payments of $10,000. Also assume that 90% of USCo’s business activities occur in China. In this case, $9,000 (90%) of the interest would be foreign source and $1,000 would be US source.

Exception No. 3: Foreign Corporations with a US trade/business

When a Foreign Corporation (ForCo) is engaged in a US trade/business it basically has a branch in the US. As we saw earlier, a branch is not a distinct legal entity. Under the General Rule, if the US trade/business of ForCo makes interest payments, those payments would be foreign source since the corporation is incorporated outside the US. However, there is an exception in this case, and the US trade/business is treated as if it is an independent corporation for purposes of the interest sourcing rules. As a result, such payments would be US source income.

Exception to the General Rule for Sourcing Dividends

The General Rule for sourcing dividends is not unlike the rule for sourcing interest: it is based on the residence of the party making the payment. Since only corporations pay dividends, all you have to do is determine where the corporation was incorporated.

There is only one exception to the General Rule and it concerns the scenario where a Foreign Corporation is paying a dividend AND that corporation is engaged in a US trade/business. In this case, if 25% or more of foreign corporation’s income is from the US trade/business, then at least a portion of the dividend will be US source income despite the fact that the corporation was not incorporated in the US.

Assume, for instance, that a Belgian corporation has $1,000,000 in sales and $300,000 of those sales are from a US trade/business. Also assume that the Belgian corporation pays a dividend of $5,000 to its shareholders. In this case, 30% of the Belgian corporation’s income is from a US trade/business so 30% of its dividend will be deemed to be US source income to the recipient. Hence, $1,500 of the dividend is US source income and the remaining $3,500 is foreign source income.

Source Rules for Income

I/ Interest:

Rule: Residence of Payor of Interest

Exceptions:

80% or more of U.S. debtor’s gross income is from “active foreign business income.”

Look to 3 taxable years prior to year of interest payment. (Look-thru subsidiaries’ dividends and look at their activities). All interest is foreign source unless lender and borrower are related parties (10% or more ownership), then split according to U.S./foreign source.

Interest paid by foreign branches of U.S. banks is foreign source.

Foreign corporations with U.S. trade or business: income paid by a U.S. T/B of a foreign corporation (e.g. paid by the U.S. branch of foreign co.) is U.S. source income.

II/ Dividends

Rule: Residence of corporation issuing the dividend

Exception:

25% or more of foreign corporation’s income is from U.S. TB. U.S. source portion of dividend equals portion of U.S. TB income. Look at last three years.

III/ Services

Rule: Where services are performed.

Exceptions:

De Minimis Exceptions: Services income is foreign source income if the taxpayer was in the U.S. no more than 90 days AND earned no more than $3000 from performing services in the U.S., AND performed the services on behalf of a foreign party or foreign branch of U.S. corp. AND the recipient is a non-resident alien.

Treaty: No more 183 days.

IV/ Rents

Rule: Where property is located.

V/ Royalties

Rule: Where intangible property is used.

VI/ Gain from the Sale of Real Estate:

Rule: Where property is located.

VII/ Gain from the Sale of Personal Property:

Rule: Residence of the seller.

Residence for this purpose = location of a “tax home” (i.e. taxpayer takes travel deductions when traveling from this location).

U.S. citizens and residents with a foreign tax home will only have foreign source income if they pay a tax of at least 10% of gain in the country…

Exceptions: U.S. resident may have foreign source income from sale of personal property if:

– office/fixed place of business in foreign country

– gain is attributable to that office

– foreign tax of 10% is PAID, and

– property is not inventory, depreciable, intangible or stock of foreign affiliate.

VIII/ Personal Property that is Depreciable/Amortizable Property: US source to the extent depreciation/amortization deductions were taken against U.S. source income.

IX/ Intangible Property

Rule: Residence of the Seller

Exception: Sourced as a royalty if income is contingent on productivity of property.

VIII/ Inventory:

Where the sale occurred: site of property when title was transferred.

IX/ Inventory manufactured in one jurisdiction and sold in another:

Where the inventory is manufactured.

Source Rules for Deductions

A/ General Rule

1 – Allocate to income item (factual relationship between income and deduction). Source is the same as the associated income item.

2- Ratable apportionment for non-related deductions (e.g. charitable contributions, medical expenses…)

B/ Interest Expense

Allocation is based on the basis assets, not income (i.e. assets producing US source income and assets producing foreign source income).

Exceptions:

Non-recourse loan for specific property.

Inbound Transactions – Non-Business Income

Now that we’ve distinguished between US persons and non-US persons we will focus strictly on non-US persons and how their activities in the US cause them to be subject to US taxation.

From the reading you will note that when we are looking at the activities of non-US persons, we distinguish between Business Income and Non-Business Income (or Investment Income):

Business Income will be taxed according the usual tax regime where we start with Gross Income, reduce it by Deductions and tax the Net Income at graduated tax rates (this is called a Net Tax).

Non-Business/Investment Income will be subject to a withholding tax of 30% on the Gross amount. In this case there is only one tax rate, 30%, and no deductions are offered (this is called a Gross Tax).

Non-Business/Investment Income is basically passive income such as interest, dividends, royalties, rents and capital gain. In other words, it is the type of income that one earns strictly from ownership of property. This income is also referred to as Fixed, Determinable, Annual & Periodic income (FDAP income), although it need not be fixed, determinable, annual or periodic.

The primary reason that the Tax Code makes a distinction between tax regimes for Business Income and Non-Business Income is because of the practicality of collecting the income. Since Investment Income merely requires ownership, it is possible for a foreign individual to own US debt, equities, intangibles or other property without having any physical presence or activities in the US. It would therefore be very difficult to collect this tax from the foreign person since they would be beyond the jurisdiction of the US. As a result, the Tax Code imposes a fixed withholding rate of 30% on this type of income. The payor of the income is responsible for withholding the amount and since the payor is within the jurisdiction of the US, they have an incentive to make these payments of the payee’s behalf.

If Investment Income is US source income it may be subject to the withholding tax. Note however, that sometimes Investment Income may be US source income but it will not be subject to the withholding tax because it falls under one of the exceptions to FDAP Income.

A Note on Tax Treaties

The US has entered into a number of Income Tax Treaties with other foreign countries. These treaties have a number of provisions that we will be discussing throughout the course. There are provisions that operate to reduce or eliminate the withholding tax on FDAP Income. Instead of requiring a 30% withholding tax, many Tax Treaties override the Code and allow for a reduced rate such as 10% withholding for dividends or no withholding for interest income (the specific reductions vary from treaty to treaty).

A Note on Capital Gain

Capital Gain is earned from the disposition or exchange of a capital asset. Capital Assets may be Personal Property or Real Property. Stocks and other securities are examples of Personal Property that generate Capital Gain. Generally, Capital Gain from Personal Property is not subject to withholding tax. Hence, a non-US person who earns Capital Gain on the disposition or exchange of Personal Property will not be subject to any US withholding tax on that gain.

Capital Gain from Real Property is taxed under a different tax regime under FIRPTA (Foreign Investment in Real Property Tax Act) which we will be discussing in two weeks. Unlike personal property, Capital Gain from the sale of US real property by a non-US person will be subject to US tax.

Summary

To recap, when you are dealing with a non-US person conduct the following analysis:

– Distinguish between business and non-business/investment income,

– Identify the non-business/investment income that is US source income,

– Determine if the income falls under one of the exceptions to FDAP,

– Apply the withholding tax of 30%, or a lower rate provided by a tax treaty.

Next week we will focus on the tax consequences of Non-US persons earning Business Income in the US.

Inbound Transactions – Business Income

“Business Income” is income that is earned through an active business in the US rather than merely through ownership of investments.

In order to be subject to US tax on business income, the non-US person must have a “US trade/business” and the income must be “Effectively Connected with that US trade/business.” We will refer to US trade/business as “USTB” and to Effectively Connected Income as “ECI”.

You will note that generally tax law is heavily codified and a great deal of clarification can usually be obtained by reading the Internal Revenue Code and the Treasury Regulations. Unfortunately, the definitions of USTB and ECI are not very clearly defined in the statutes. When confronted with USTB and ECI issues it is necessary to look at them on a fact-by-fact basis to reach a decision. Because of the lack of clarity it is always best to err on the side of caution when conducting tax planning in this area.

US Trade/Business

A USTB is generally defined as regular, continuous and considerable business activities in the US. As you have seen in the reading, case law has set a low threshold as to what constitutes a USTB.

There are many examples that are clearly a USTB such as manufacturing in the US, maintaining a research & development facility, carrying inventory, maintaining a sales force that actively sells and negotiates deals in the US, or performing services in the US.

A physical office in not necessary to create a USTB, if a foreign corporation has a sales force in the US that may be sufficient.

Agency

It is possible that a Foreign person (or corporation) has no presence in the US but will still be deemed to have a USTB as a result of an agent in the US that acts on its behalf.

In order to determine whether a US party is an agent to a Foreign person you should look for three things in the arrangement between the parties:

Does the Foreign Person have control over the US party’s activities? Does the US party need approval from the Foreign Person in order to take important actions?

Does the Foreign Person maintain Risk of Loss with respect to the activities in the US?

Does the US party act exclusively on the Foreign Person’s behalf?

Consider the facts of Revenue Ruling 70-424:

ForCo and USCo enter into an agreement under which ForCo conveys to USCo sole agency for sale of its products in the US. USCo will receive a commission of the sales price. [Exclusivity]

USCo agrees not to make sales of the same kind of products of any other company without ForCo’s permission. [Exclusivity]

USCo agrees not to sell ForCo’s products outside the US without permission. [Approval/Control]

USCo will secure yearly contracts with US end-buyers, subject to the approval of ForCo [Approval/Control]

USCo assumes full responsibility for the sale of ForCo’s products and acts as guarantor. [Risk]

ForCo will share equally any loss incurred by USCo. [Risk]

The IRS concluded that this created an agency relationship and ForCo was deemed to have a USTB even though it wasn’t directly conducting activities in the US.

In short, what you’re asking is whether the US party is acting more like an employee of the Foreign Person than an independent third party acting on its own behalf. So if there is a legitimate Buy-Sell arrangement between the Foreign Person and the US party, then the US party would not be an agent but merely a business partner acting on its own behalf.

Effectively Connected Income

Once you’ve determined that there is a US trade/business, you must now look at that business’ income and determine whether that income is Effectively Connected with the US trade/business.

The short answer is: If a Foreign Person has a USTB and he/she earned US source income that is not FDAP income, then that income is ECI.

Income that is Effectively Connected with a US trade/business is taxed under a Net Tax regime in much the same way US persons are taxed:

– Start with Gross Income that is Effectively Connected with the US trade/business

– Reduce it by deductions

– Apply the marginal tax rate to the net amount

There are certain situations in which FDAP income and Foreign Source income can be ECI as well:

FDAP income that is ECI

FDAP-type income (interest, dividends, royalties, rent, capital gain) are generally taxed under the withholding tax regime as we discussed last week. However, if the FDAP income passes the Asset-Use test or the Business Activities test, then it will be taxed according to the USTB regime.

Asset-use test: If the asset that is producing the FDAP income is used in the USTB, then the FDAP income will be ECI. Examples of a FDAP asset used in a USTB include the following:

– Plant, equipment or vehicle used in the daily conduct of the business,

– Securities and investments if they are held to meet the present cash needs of the business,

– FDAP-type assets acquired with the funds of the USTB and actively managed by the USTB.

Business Activities test: If the USTB consists of making investments or licensing then, under the Business Activities test, any dividends, interest and royalties would be ECI and taxed accordingly.

Foreign Source Income that is ECI

Foreign source income will only be ECI if the foreign source income is attributable to a US office or fixed place of business.

If a Foreign Corporation has a sales force present in the US, then it would have a USTB but not necessarily a US office or fixed place of business.

With respect to the sale of inventory, even if the Foreign Corporation has a US office/fixed place of business, and foreign source income is attributable to that office, the foreign source income may still avoid being ECI if a foreign office materially participates in the sale and that inventory is not used in the US.

Treaty Modifications: Replace the USTB analysis with the PE analysis

The ECI/USTB standard of analysis only applies if the Foreign Person is from a country that does not have an Income Tax Treaty with the US.

If there is an Income Tax Treaty in effect, then a similar, but more lenient standard is applied: In order to be subject to US tax on business income, the Foreign Person/Corporation would need to have a Permanent Establishment (PE) in the US rather than merely a US trade/business. The threshold for having a PE is must higher than for having a USTB. There are generally two types of PEs, a physical PE or an agency PE:

Physical PE

In order to have a physical PE, you need a fixed place of business. So, unlike a USTB, it is not enough to have a sales force roaming the US, they actually need to be working out of an office. Unless you have some type of physical structure like an office, factory, laboratory, a warehouse, etc…you do not have a PE. Basically, you are looking for a distinct place with some degree of permanence.

Most treaties also list a number of activities that do not constitute a PE including a facility in the US that is used merely for storing, purchasing, displaying and delivering goods, collecting information or other auxiliary or ancillary functions.

Agency PE

Earlier we saw that an agent can create a USTB for a foreign person. Similarly, under a tax treaty an agent can create a PE. In order for an agent to create a PE, the agent must be a Dependent Agent of the Foreign Person (as opposed to an Independent Agent). A Dependent Agent is one with the authority to conclude contracts in the name of the Foreign Person and habitually exercises that authority. If a Foreign Person has a Dependent Agent in the US, they would have a PE even though the Foreign Person or the Dependent Agent has no physical structure in the US.

I will elaborate on the following four areas:

Capital Gains Received by Non-US Persons

The Mechanics of the Withholding Tax

Foreign Source ECI and

the Consequences of Having a US Subsidiary

Capital Gains Received by Non-US Persons

Generally, if a Non-US Person receives US source capital gain AND the capital gain is not effectively connected with a US trade/business, then the Non-US Person is not subject to US tax on that gain.

If the non-US person has no US trade/business, then no taxes will be imposed on the capital gain earned by such a person.

If the non-US person has a US trade/business, then capital gain may be subject to US tax if it is ECI. In order for it to be ECI it must meet the asset-use test or the business activities test (see Lecture 4).

The policy behind the limitations on taxation of capital gains received by non-US persons is to encourage foreign investment in the US.

Typically, when an intangible asset is sold, the gain constitutes capital gain and it would not be subject to withholding tax. However, if the sales price is contingent on the property’s productivity, use or disposition then it will be sourced as a royalty and subject to withholding tax accordingly.

Mechanics of the Withholding Tax

The reason the Tax Code imposes a withholding tax on investment revenue received by non-US persons is because it is the most practical way of collecting the tax. Generally, the withholding agent must withhold 30% of the revenue (or a lesser amount directed by a Treaty). The withholding agent is the person in the US who last handles the item of income before it is remitted to the taxpayer or a foreign intermediary. So if a corporation pays a dividend to a foreign person, the corporation is the withholding agent. However, if the corporation pays a dividend to a US stock broker who then remits it to a foreign person, then the stock broker is the withholding agent.

The withholding agent has an obligation to withhold if they have been notified that the payee is foreign or if they have reason to assume that the payee is foreign. For instance, if the payee provides a foreign address or does not present a Taxpayer Identification Number, the withholding agent should assume the payee is foreign. A foreign person should notify the withholding agent of their foreign status by providing them with a withholding certificate (Form 8233). If there is an Income Tax Treaty that reduces the rate, it is the payee’s obligation to inform the withholding agent that a lower rate applies.

Foreign Source ECI

Last week we saw that when you’ve established that a non-US person has a US trade/business, all US source income will be ECI except FDAP income that does not meet the “Asset-Use” test or the “Business Activities” test.

Foreign Source income may also be ECI with a USTB; however there are a number of restrictions for it to be included as such.

First, you need an office or fixed facility in the US. Remember it is possible to have a USTB without an office or fixed facility. However, it is not possible to have Foreign Source ECI without an office or fixed facility. So if a Foreign Corporation has a sales force present in the US without an actual office, no Foreign Source income would be ECI no matter how related it is to the activities in the US.

Also, be aware that if the Foreign Corporation merely has a US subsidiary with an office that, in and of itself, will not create an office for the Foreign Corporation. If the US subsidiary is acting as the Foreign Corporation’s agent, then its office may create an office for the Foreign Corporation (more on the consequences of having a US subsidiary later).

Once you’ve determined that there is a USTB with an office or fixed facility it is time to ask the second question: Is the item of Foreign Source income ATTRIBUTABLE to the US office? In other words, does the US office MATERIALLY PARTICPATE in the production of the item of Foreign Source income?

This is where things get tricky. Establishing that there is an US office if pretty straight forward. But it’s harder to determine if the US office materially participates in the production of an item of Foreign Source income. The standard of “materially participates” is difficult to grasp. It is necessary to apply it on an item-by-item basis:

Royalties and Rents

We can conclude that a US office materially participates in the production of Foreign Source Royalties and Rents if that office actively participates in soliciting, negotiating, or performing other activities required to arrange or service the lease/license. General supervision by the US office of such activities is insufficient to constitute materially participation. The US office’s personnel must actually perform such services. The following activities alone will not constitute material participation:

Creation, development or purchase of licensed property,
Collecting or accounting for royalties or rents,
Performing clerical functions
Exercising final approval over the execution of licenses/leases

Dividends and Interest

In order for dividends and interest to be attributable to a US office, the dividends/interest must be derived in the active conduct of a banking, financing or similar business in the US. This is not unlike the “business activities” for FDAP income. Basically, if you are not dealing with a banking or financing business then Foreign Source dividends/interest will not be ECI.

Sales Income

The General Rule is that Foreign Source income from the sale of personal property is ECI if it is made through the taxpayer’s office.

Assume that a Foreign Corporation (ForCo) has a sales office in the US that sells encyclopedias. There is a sales force in the US that calls individuals in the US and Canada and sells them the encyclopedias. The terms of the contract state that title transfers upon receipt by the customer. Since title transfers to the Canadian customers upon receipt in Canada, such income is foreign source income (the sourcing rule for inventory is based on where title is transferred). Because the sale was made through the US office, the foreign source income from the sale is ECI.

There is an exception to the above rule. Even if the sale is made through a US office, the Foreign Source income will NOT be ECI if an office of the taxpayer in a foreign country participates materially in the sale.

So back to our example: Assume the same facts as above except that ForCo also has an office in Canada that produces marketing material for the encyclopedias sold in Canada. One may argue that the Canadian office also materially participates in the sale and therefore the Foreign Source income from the sale of encyclopedias in Canada is not ECI.

Consequences of Having a US Subsidiary

A general rule that you should remember is that if a Foreign shareholder (or a Foreign Corporation) owns shares in a US corporation, that alone is not enough to create a US trade/business.

Assume that a Foreign Corporation, a foreign corporation, (ForCo) owns 100% of the shares of a US Corporation (USSub). ForCo makes bicycles and sells them in France directly to retailers. ForCo also sells the bicycles to USCo and USCo sells them to retailers in the US.

The fact that ForCo owns 100% of USCo is not enough to create USTB for ForCo. Remember that mere ownership is not enough to create a USTB.

Since ForCo does not have any of its own employees in the US (the US sales force is employed by USCo), the only way that ForCo could have a USTB is if USCo was acting as ForCo’s agent. In the facts above, there is an arm’s length Buy-Sell arrangement between ForCo and USCo. USCo assumes all risk on the sales of the bikes and concludes contracts on its own behalf. Since USCo is acting independently of ForCo, USCo is not ForCo’s agent and ForCo does not have a USTB. Note that USCo will be subject to US tax on the sale of the bikes just as any other US person would be, however ForCo would not be subject to US tax.

Now assume that the terms of the agreement between ForCo and USCo are different. Assume that instead of a buy-sell arrangement, ForCo commissions USCo to sell the bikes for it and compensates USCo with a percentage of the sale. ForCo maintains ownership of the inventory and has final approval of all contracts. In this case USCo is not acting independently of ForCo. We can conclude that since USCo is ForCo’s agent, ForCo has a USTB through USCo and ForCo will be subject to US tax on its ECI.

Assume that ForCo also had a wine business that was wholly unrelated to the bike business and ForCo sold wine through mail-order directly to US consumers (without the involvement of USCo). If title to the wine passes upon receipt by the customers in the US the income would be US source income. Even though it has nothing to do with the bike business and USCo played no role in the wine sales, the wine income would be ECI because it is US source income and ForCo had a USTB (through USCo).

I know this is complicated but here are some simple rules that you should remember:

Ownership of a US corporation is not enough to create a USTB.

You should analyze the relationship between a Foreign person/corporation and its US corporation the same way you would analyze the relationship between the Foreign person/corporation and an unrelated agent in the US.

If you have a USTB, all non-FDAP US source income earned by the non-US person will be ECI even if it is entirely unrelated to the USTB.

Planning Note: It is generally preferable for a Foreign Person to incorporate its US activities and to have the US corporation act on its own behalf in order to prevent the Foreign Person from having ECI. The only time a Foreign Person would want to conduct activities in the US directly (i.e. without incorporating) is if it had losses in the US.

Decision Tree 1: Inbound Transactions

Analysis for Foreign Persons or Foreign Corporations

Step 1: Is there a Tax Treaty between the Foreign Person/Corporation?s jurisdiction and the U.S. If so, go to Step 4, if not, go to Step 2.

Step 2: If there is not a Tax Treaty in effect, determine if there is a U.S. Trade or Business. If there is no U.S. Trade/Business, go to Step 6. If there is a U.S. Trade/Business, go to Step 3.

Question 1: Are there Regular, Continuous & Considerable Business Activities in the U.S.? (Consider the presence of employees or a fixed place of business).
Question 2: Is there an Active Business or Mere Ownership?
Question 3: Is there an agent in the U.S.? (Consider exclusivity, risk of loss, approval requirements, extent of agent?s responsibility).
Question 4: Is there a Buy-Sell arrangement with parties in the U.S. or a Consignment arrangement?

Step 3: If there is a U.S. Trade or Business, determine if there is Effectively Connected Income. If there is U.S. source income that is not ECI, go to Step 6. If there is ECI go to Step 8.

Question 1: Is there U.S. source income that would not be considered FDAP? If so, it is likely that this income is ECI.
Question 2: If there is U.S. source income that would be considered FDAP, does it satisfy the Asset-Test or the Material Factor Test?
Question 3: Is there any Foreign source income that is ATTRIBUTABLE to an OFFICE OR FIXED PLACE OF BUSINESS in the U.S. and does that office MATERIALLY PARTICIPATE in the production of income?

– Sub Question A: Is there an Office or Fixed Place of Business? If not, do not include any Foreign Source income as ECI.

– Sub Question B: If there is an Office or Fixed Place of Business, does it provide significant contribution (essential factor) to earning the income? If not, do not include any of that Foreign Source income as ECI.

– Sub Question C: If the income is from the use, consumption or disposition of goods outside the U.S., does a Foreign Office also materially participate? If so, do not include that income as ECI.

Step 4: If there is a Tax Treaty in effect, determine if there is a Permanent Establishment in the U.S. and if there are Business Profits attributable to that Permanent Establishment? If there is U.S. source income and there is no Permanent Establishment, go to Step 7. If there are Business Profits attributable to a Permanent Establishment, go to Step 9.

Question 1: Is there a Fixed Place of Business (other than those that qualify as exceptions: purchasing, storing, displaying & delivering goods, collecting information or other auxiliary or ancillary task).
Question 2: If there is not a direct Fixed Place of Business, is there a Permanent Establishment through a Dependent Agent?

– Sub Question A: Does the agent habitually exercise the authority to make contracts on the principal?s behalf?

Step 5: If there is a Permanent Establishment, determine the Business Profits attributable to the Permanent Establishment (profits derived from the assets or activities of the Permanent Establishment).

Step 6: If there is not a U.S. Trade or Business, or if there is U.S. source income that is not ECI, determine if withholding tax applies to the U.S. source income.

Question 1: Is the income U.S. source Dividend, Interest, Royalty, Rental, Services Income or other FDAP Income that is not ECI? If so, determine if any exceptions apply and apply the withholding tax to the gross amount?
Question 2: Is there is U.S. source Capital Gain that is not ECI and is not from the sale of Real Property? If so, no tax applies.

Step 7: If there is not a Permanent Establishment but there is U.S. source income, determine if a withholding tax applies to the U.S. source income under the Treaty.

Question 1: Is the income U.S. source Dividend, Interest, Royalty, Rental, Services Income or other FDAP Income that is not ECI? If so, determine if these types of income are subject to tax under the Treaty and apply the appropriate withholding tax to the gross amount?
Question 2: Is the income U.S. source Capital Gain that is not ECI and is not from the sale of Real Property? If so, no tax applies.

Step 8: If there is ECI, include it as income on the U.S. tax return and deduct allocated expenses. Apply appropriate tax credits, including foreign tax credits, to reduce the tax liability. Apply the Branch Profits Tax withholding tax to any Effectively-Connected E&P adjusted by Changes in Net Assets.

Step 9: If there are Business Profits attributable to a Permanent Establishment, include it as income on the U.S. tax return and deduct allocated expenses. Apply appropriate tax credits, including foreign tax credits, to reduce the tax liability. Apply the Treaty-Prescribed Branch Profits withholding tax to any Effectively-Connected E&P adjusted by Changes in Net Assets.

Branch Profits Tax and FIRPTA

Where we are to date:

Now would be a good time to review the different concepts we covered and how they all fit together.

Question 1: Is the taxpayer a US person or a non-US person?

For any issue you are faced with in international tax, this is always the first issue you must resolve.

Question 2: What is the source of the income?

The source of income is also relevant to further analysis you will be conducting.

If you’ve determined that you are dealing with a non-US person, there are 2 important questions you must ask:

1- Is the non-US person a resident of a country that has a tax treaty with the US?

2- Does the non-US person have a US trade/business or a Permanent Establishment (if there is a Treaty in effect)?

I have created a decision tree that will help you get through the various questions that arise for non-US persons.

Branch Profits Tax

The Branch Profits Tax (BPT) was created to create parity between the situation when a non-US person has a US subsidiary and when a non-US person has a US branch.

Consider the following two scenarios:

Scenario 1:

A foreign corporation (ForCo) owns 100% of the shares of a US corporation (USSub)

USSub earns $1000 of income that is subject to corporate tax at the normal marginal rates (let’s assume the applicable rate is 35%), resulting in $350 of tax.

The remaining $650 is distributed to ForCo as a dividend. Since the $650 dividend is FDAP income (and no exception applies), it is subject to the 30% withholding tax.

After $195 is withheld, ForCo receives a payment of $455 from USSub.

Scenario 2:

A foreign corporation (ForCo) is engaged in a US trade/business. Since the US business is unincorporated it is a branch. The US branch earns $1000 of income which is ECI. The income is therefore subject to tax at normal marginal rates (let’s assume it’s taxed at 35%), resulting in $350 of tax.

When the remaining $650 is remitted to ForCo, the income is not characterized as FDAP income. In this case the $650 does not constitute a dividend payment (since it is not a distribution of earnings from a corporation to a shareholder); it is merely an inter-company payment that is only reflected on the company’s internal books.

After the inter-company is payment is made ForCo would have $650 from the US branch.

As you can see, by having a US branch instead of a US subsidiary ForCo was able to bypass the 30% withholding tax. The BPT steps in to remedy this difference. Essentially, the BPT treats a branch as if it was a subsidiary by imposing a 30% withholding tax on a branch’s earnings that are deemed to be distributed to the foreign corporation.

The difficulty is in determining the “deemed dividend amount.” A US subsidiary has the discrepancy of distributing any amount it chooses to its shareholders. So if USSub earned $650 after-corporate taxes, it could choose to pay a dividend anywhere from $0 to $650. It would therefore be too simple to assume that the “deemed dividend amount” of a branch was merely its after-tax ECI. We have to account for the potential that the branch may have re-invested some of its earnings into the US operations. As a result, the “deemed dividend amount” is reached by performing the following calculation:

Determine the US trade/business’ ECI ($1000 in our example)

Subject the ECI to the appropriate marginal tax rate (35% in our example)

Post-tax ECI is Effectively Connected Earnings & Profits ($650 in our example)

In order to account for reinvestments in the US operations, we need to adjust the Effectively Connected Earnings & Profits by changes in the branch’s Net Assets.

So we need to look at the branch’s balance sheet for the prior year and the current year and determine whether the Net Assets increased or decreased. Assume that at the end of the prior year, the branch’s Net Assets were at $450 and at the end of the current year the branch’s Net Assets were at $500. We can conclude that the Change in Net Assets was $50.

When there is an increase in Net Assets, we assume that there was a reinvestment into the branch’s operations. Hence, we assume that of the $650 of Effectively Connected E&P, $50 was reinvested into the branch, leaving only $600 to be distributed to the Foreign Corporation. In this example, a 30% withholding tax would be imposed on $600.

FIRPTA

We discovered in the last two weeks that non-US persons are generally not subject to US tax on their US source capital gains unless they are ECI with a US trade/business.

The major exception to this rule is in the case of Real Property. Capital gain realized by non-US persons from the sale of Real Property is subject to tax at normal tax rates (i.e. ordinary income rates for short-term capital gain and capital gains rates for long-term capital gain).

However, imagine that a non-US person created a US corporation (USCo) and the only asset that the USCo owned was US real property. At first, it would appear that if the non-US person sold shares in USCo, it would not be subject to any tax because shares of stock are personal property, not real property.

In order to curtail this abuse, the tax code will treat a US corporation as a US Real Property Holding Company (USRPHC) if 50% or more of its assets are a US Real Property Interest (USRPI). The sale of shares of a USRPHC is treated the same as the sale of Real Estate.

A USRPI includes most forms of Real Estate (e.g. buildings, land, etc…) as well as other USRPHCs. So if a US corporation’s (USCo1) only asset is stock in another US corporation (USCo2), and USCo2’s only asset is a building, then both USCo1 and USCo2 are USRPHCs.

To determine if you reached the 50% threshold for a USRPHC perform the following formula:

USRPI (including other USRPHCs) / USRPI (including other USRPHCs) + Foreign Real Property + All other assets used in a trade/business

Note that passive assets are not included in the formula. So if a US corporation owned $100 worth of US Real Property and $300 of bonds and $50 of trade/business assets, it would be a USRPHC because the USRPI would be more than 50% of the RELEVANT assets:

USRPI ($100) / USRPI ($100) + trade/business assets ($50) = $100/$150 = 67%

The investment assets of $300 are NOT included in the denominator of the formula.

Subpart F Income

When a US person owns shares in a Foreign Corporation you must ask two questions: 1/ Is the Foreign Corporation a CFC? 2/ If so, did the Corporation earn Subpart F income?

Last week we reviewed the test to establish whether a Foreign Corporation is a CFC. This week we will focus on the second question: Did the Foreign Corporation earn Subpart F income?

Subpart F income is income that was probably shifted offshore strictly for tax purposes. If there is a legitimate business purpose for earning income offshore, it is usually not characterized as Subpart F income.

Subpart F income includes several different categories of income, we will focus on Foreign Base Holding Company Income (FBHC) and Foreign Base Company Sales Income (FBC Sales Income).

Foreign Base Holding Company Income

FBHCI is investment income that is moved offshore. Remember the first example in Lecture 6 where a US person transferred the ownership of his international portfolio to a Foreign Corporation. This is the type of transaction that typically creates FBHCI. Generally, whenever a CFC earns dividends, interest, royalties or rent or capital gain from the sale of investment income producing property, such income is FBHCI. This is because this type of income is easy to move offshore and there is no reason for it to be earned offshore as opposed to in the US. There are some exceptions:

Rents and Royalties from an Active Trade/Business and received from a Non-Related Party

When the CFC has active rental or licensing income from an unrelated party there is more evidence that the offshore company is located there for legitimate business reasons rather than tax reasons alone.

Regular Dealer or Active Banking Business Exception

When the CFC is conducting an active banking business or when the CFC is a regular dealer in investment properties (e.g. stock brokerage business) there is more evidence that the offshore company is located there for legitimate business reasons rather than tax reasons alone.

Same Country and from a Related Party Exception

When a CFC receives investment income from a related party from the country in which the CFC is incorporated, there is a legitimate business reason for the existence of the CFC. For instance, assume that Ted, a US shareholder, owns 100% of a Dutch holding company (HoldCo). The Dutch holding company owns shares in other companies throughout Europe including a company in the Netherlands (DutchCo). Also assume that DutchCo only earns non-Subpart F income (see Scenario B in the attachment). Dividend payments from DutchCo to HoldCo would normally be considered FBHCI since they are dividends received by a CFC. However, since the dividend was from a related party in the same country (both HoldCo and DutchCo are Dutch), an exception applies and the income is not Subpart F income. The legislators saw no reason to tax US shareholders on dividends received by a CFC (HoldCo) from a related party in the same country where the US shareholder would not have been taxed if he had owned the stock of the related party (DutchCo) directly (in Scenario A, the dividend payment would not exist). The conclusion is that there must be a legitimate business reason for creating HoldCo since the taxpayer could have avoided the dividend income altogether by not creating HoldCo in the first place.

There is an exception to this exception (and this is where it gets tricky). Assume the same facts as above, a Dutch company (HoldCo) owning 100% of another Dutch company (DutchCo). However, this time assume that DutchCo earns $500 of Subpart F income and $500 of non-Subpart F income. DutchCo received a loan from HoldCo and makes interest payments of $1000 (see Scenario C). Both HoldCo and DutchCo are CFCs so we need to determine if either one has Subpart F income that Ted needs to include currently in his gross income.

DutchCo had $500 of Subpart F income and $500 of non-Subpart F income, however it made an interest payment of $1000, so DutchCo’s net income is $0 and there is no income for Ted to include in his gross income.

HoldCo had $1000 of interest income which would normally be Subpart F income. However, since it was received from a related party in the same country the exception applies. As a result Ted does not include this amount in his gross income either.

You will note that Ted does not include anything in his gross income even though DutchCo had $500 of Subpart F income. This income was reduced to $0 as a result of the interest payment from DutchCo to HoldCo. Since $500 of the interest payment from DutchCo to HoldCo served to reduce Ted’s Subpart F inclusion, the exception will not apply to that amount. As a result of the exception to the exception HoldCo is deemed to have $500 of Subpart F income since the payment from DuthCo to HoldCo served to reduce Ted’s overall Subpart F income inclusion by $500.

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Foreign Base Sales Income

Sales income earned by a CFC is Subpart F income when the buyer or seller are related parties. If a CFC buys goods from unrelated parties and then sells them to unrelated parties, there is no Subpart F income.

There are two exceptions to FBC Sales Income:

Same Country Exception

If the goods that are being sold were manufactured in the CFC’s country or if they were sold in the CFC’s country, the income is not Subpart F income.

Example 1: A US shareholder owns 100% of the shares of a CFC in Hong Kong (HKCo) and 100% of the shares of a US corporation (USCo). HKCo buys goods from USCo and sells them to retailers in Hong Kong. The income received is not Subpart F income even though the seller is a related party because the goods were sold in the CFC’s country.

Example 2: Same as above except instead of selling the goods to retailers in Hong Kong, HKCo sells the goods to a distributor in Hong Kong that resells them to retailers throughout Asia (outside Hong Kong). If HKCo knows, or has reason to know, that the end user of the goods is outside of the CFC’s country of incorporation (Hong Kong), then the exception does not apply and the income is Subpart F income.

Manufacturing Exception

If the goods sold by the CFC were manufactured by the CFC, the income is not Subpart F income. Manufacturing is defined as Substantial Transformation of the product. So merely packaging or labeling will not qualify as a product. Assembly may qualify as manufacturing if an entirely different product results after the assembly occurs. Note that the manufacturing does not need to occur in the CFC’s country of incorporation for this to apply.

Example 1: A US shareholder owns 100% of the shares of a CFC in the Netherlands (DutchCo). DutchCo owns a manufacturing operation in Ireland (since the operation is not independently incorporated it is a branch of DutchCo). DutchCo sells the goods manufactured by the Irish branch throughout Europe. The income received is not Subpart F income because the goods were manufactured by the CFC (in its Irish branch).

Example 2: A US shareholder owns 100% of the shares of a CFC in the Netherlands (DutchCo). DutchCo enters into an agreement with an unrelated third party (MfgCo) to perform manufacturing on its behalf. Under the agreement, DutchCo retains all risk of loss and owns the raw materials used in the manufacturing. MfGCo performs the manufacturing services for a cost plus mark-up fee. DutchCo sells the goods manufactured by the contract manufacturer throughout Europe. The income received is not Subpart F income because the goods are deemed to be manufactured by the CFC. Even though the CFC does not manufacture the goods itself, if it enters into a contract manufacturing agreement with a third party manufacturer it is deemed to have performed the manufacturing.

Note: Even though Rev. Rul. 97-48 appears to invalidate this position, tax planners have successfully relied on general agency law to argue that manufacturing performed by a contract manufacturer may be deemed to be performed by a CFC.

Relief Provisions

High-Tax Exception

If the CFC’s income is subject to an effective tax rate that is greater than 90% of the maximum US corporate tax rate, none of the Subpart F income is included in the taxpayer’s gross income. If the maximum US corporate tax rate is 35%, then the CFC’s Subpart F income will not be included in the taxpayer’s gross income if its income is subject to a rate of 32% since this is higher than 31.5% (90% of 35%).

The theory is that the CFC was not set up for tax avoidance purposes if its income is subject to a rate of tax that is about as high, or higher, than the US tax rate.

DeMinimis Exception

If the proportion of Subpart F income to total income (Subpart F and non-Subpart F) falls below a certain threshold, then NONE of the income is Subpart F income. The threshold is the lesser of $1,000,000 or 5% of the CFC’s gross income.

If the CFC had $900,000 of Subpart F income and $19,000,000 of non-Subpart F income, the $900,000 of Subpart F income would not be included in the taxpayer’s gross income since it is less than 5% of the CFC’s gross income. ($900,000 is 4.5% of $19,900,000).

If a CFC had $700,000 of Subpart F income and $10,000,000 of non-Subpart F income, the $700,000 of Subpart F income would be included in the taxpayer’s gross income since it is greater than 5% of the CFC’s gross income ($700,000 is 6.5% of $10,700,000).

If the CFC had $2,000,000 of Subpart F income and $45,000,000 of non-Subpart F income, the $2,000,000 of Subpart F income would be included in the taxpayer’s gross income since it is more than $1,000,000 (even though it is less than 2,350,000 – 5% of $47M).

Full Inclusion Rule

This is the opposite of the DeMinimis Exception. Basically, if most of the CFC’s income is Subpart F income (70% or more), then all of it will have to be currently included in the taxpayer’s gross income. So if a CFC had $800,000 of Subpart F income and $200,000 of non-Subpart F income, the entire $1,000,000 would be currently included in the taxpayer’s gross income because $800,000 is 80% of the CFC’s total income.

Non-Subpart F Income

With regard to non-Subpart F income, the CFC is treated as a regular foreign corporation and the income is not subject to US tax until such time that the income is repatriated to a US person as a dividend.

So if a CFC receives $1,000,000 of non-Subpart F income in Year 1 and the income is not distributed to a US person until Year 4, that $1,000,000 will not be subject to US tax until Year 4 when it will be taxed at US tax rates to the shareholder.

New Law: However, under the Tax Cuts and Jobs Act of 2017 there is an exception to the general rule above for 2017. At the end of 2017, all non-Subpart F income that has been retained by a CFC is deemed to distribute that income to its US shareholders. The tax rate for this undistributed income is 15.5% to the extent that it is attributable to cash and 8% to the extent it is attributable to other assets.

For example, assume that in 2016 a CFC had $400,000 of Subpart F income and $500,000 of non-Subpart F income and in 2017 the CFC has no income. Also assume that of that $500,000, $300,000 is cash and $200,000 is non-cash assets.

In 2016, the US shareholders would be subject to tax on the $400,000 as if it was distributed to them. Because of the new law, in 2017 the CFC will be deemed to have distributed the $500,000 to its US shareholders and they would be taxed at 15.5% on the $300,000 of accumulated cash and 8% on the $200,000 of non-cash assets.

Note that this deemed distribution is a one-time event for the end of 2017. For subsequent years the default law will apply whereby non-Subpart F income is not deemed to be distributed to US shareholder and is therefore not subject to US tax until such time that it is acutally distributed.

A Brief Note on PFICs

PFICs can be complicated but here are the essential issues you should understand:

Once you’ve conducted a thorough CFC/Subpart F analysis and determined that the taxpayer does not have to currently include any of the Foreign Corporation’s income in his gross income, you then need to conduct a PFIC analysis.

Generally, when a US Person owns shares of a Foreign Corporation the PFIC rules could potentially apply. The key distinction between PFICs and CFCs is that CFCs only have consequences for US Shareholders (i.e. 10% or more owners) whereas PFICs have consequences for any US Person who owns shares of a Foreign Corporation (even a US person who owns 1 share of a Foreign Corporation needs to be concerned).

So once we’ve identified a Foreign Corporation that is owned in some part by a US person, we need to determine if that Foreign Corporation is a PFIC. It will be a PFIC if it meets either of the two following tests:

Income Test: If 75% or more of the Foreign Corporation’s income is FPHCI (i.e. passive investment income or investment capital gain), then it is a PFIC.

Asset Test: If 50% or more of the Foreign Corporation’s assets produce FPHCI, then it is a PFIC.

If the Foreign Corporation is a PFIC the US person taxpayer will face one of the following consequences:

1 – Excess Distribution: When the PFIC makes an excess distribution (125% of previous year’s distribution) or when the PFIC stock is sold, the taxpayer is taxed on the income as if it was earned in the year the PFIC earned the income (applying the tax rate of that year and interest due). This is the default rule and will apply unless the taxpayer makes an election otherwise.

2 – QEF Election: If a QEF election is made, the PFIC is treated as if it distributed all its income in the year it was earned (this is a similar treatment that Subpart F income receives in the CFC regime).

3- Mark-to-Market Election: Current inclusion of the difference between the taxpayer’s basis in the PFIC stock and its market value on a public exchange at the end of the year (the PFIC’s stock must be publicly trade for this election to apply).

It is possible that a corporation can be a CFC and a PFIC at the same time. If this is the case, only the CFC regime will apply for US shareholders. The PFIC regime will continue to apply for non-US shareholders who are US persons.

Transfer Pricing and Transfer of Property Outside the US

Transfer Pricing

Transfer Pricing is one of the most well known areas of International Tax (probably because it often results in high-profile litigation). In practice, Transfer Pricing issues are more often within the domain of economists than tax professionals since, ultimately, the questions that need to be resolved are economic questions rather than legislative ones.

Transfer Pricing rules were introduced to control the following abuses:

Assume that a multinational corporation, WorldCo, has two subsidiaries, one in the US (USCo) and one in Hong Kong (HKCo). Hong Kong taxes HKCo at a rate of 10% whereas the United States taxes USCo at a rate of 35%. USCo manufactures radios and sells them to HKCo. HKCo distributes the radios to retailers in Hong Kong. The cost to manufacture the radios is $5 per unit and the sales price to retailers is $20 per unit. The $15 of gain is realized by the WorldCo enterprise regardless of the portion earned by USCo or HKCo.

It is therefore in WorldCo’s interest to set the intercompany price between USCo and HKCo as low as possible. For example, if USCo sold the radios to HKCo for $7, there would be $2 of gain attributed to USCo that would be taxed at 35%. Meanwhile, $13 of gain would be attributed to HKCo and taxed at only 10%. By shifting more of the gain to HKCo, which is in a lower tax jurisdiction, WorldCo can minimize the amount of tax it pays on the transaction. It does not matter to USCo that it is being short-changed since it is part of the same enterprise as WorldCo and, ultimately, WorldCo’s shareholders will receive the entire $15 of gain (no matter how it is spread between USCo and HKCo).

If HKCo was unrelated to USCo, USCo would never tolerate a price as low as $7 since $2 gain is well below the acceptable mark-up for radios. The IRS aims to ensure that the prices in intercompany transactions do not deviate from the prices that would exist between unrelated parties. The purpose of the Transfer Pricing rules is to require related parties to charge each other “arm’s length” prices for goods and services (i.e. prices that would be excepted if the transactions were between unrelated parties).

Transfer Pricing Methods

The tricky part is to determine what the appropriate intercompany price should be – what price would reflect a transaction between independent parties. There are three generally accepted methods to establish the proper transfer price:

Comparable Uncontrolled Price (“CUP”) Method

Under this method, you find comparable transactions between unrelated parties and look at the price that is charged between those parties. For instance, if another US company manufactured similar radios for $5 and sold them to an unrelated distributor in Hong Kong for $10, the CUP Method would require USCo to charge $10 to HKCo for the radios it sells.

Since it is difficult to find exact comparables, certain adjustments must often be made.

Resale Price (“RSP”) Method

In this case we are not looking at comparable products, but comparable distribution functions. We look at the gross profit margin that is realized by an unrelated distributor and apply that gross profit margin to our distributor (HKCo).

If no other company in the US manufactures radios we could not use the CUP method. However, assume that we identify a Hong Kong company that distributes televisions. Assume that this other Hong Kong company buys the TVs from an unrelated party for $20 per unit and sells them to retailers for $45 per unit. The gross profit margin is 56% (($45-$20) / $45). Using the RSP method, we can conclude that the gross profit margin realized by HKCo should also be 56%. Since HKCo charges the retailers $20, a 56% gross profit margin would be $11.20. In order to receive $11.20 of profit it must have paid USCo $8.80 for the radios. Hence, using the RSP method $8.80 should be the appropriate intercompany price.

Notice two things: 1/ We don’t need comparable goods using this method, only comparable distribution services, 2/ We work backwards from the sale price to the retailers (remember we can be assured that the $20 charged to retailers is a fair market price since the retailers are unrelated to HKCo and wouldn’t tolerate a higher price).

Cost Plus Method (“CPM”)

This method is appropriate where there are no comparable products or any comparable distribution services (e.g. HKCo does more than just distribute the goods, it also provides unique services). In this case we apply an appropriate gross-profit mark-up to the manufacturer’s costs to determine the intercompany price.

Assume that we determine that there is a manufacturer selling MP3 players to unrelated parties for a mark-up of 80%. We can therefore apply this mark-up to USCo’s radios: since it costs USCo $5 to manufacture the radios, an 80% mark-up would result in a distributor sales price of $9 ($5 + (80% x $5)).

Notice that in this case we are working forward, starting with the costs and adding a mark-up.

The appropriate method to be selected depends on the comparable information that is available. Generally, the Cost-Plus method appears to be the method that is most commonly used.

Transfer of Property Outside the US

Section 367 of the Tax Code, which discusses the transfer of property outside the US, is where corporate tax meets international tax. Those of you who have already taken corporate tax will be familiar with some of the concepts we will discuss. For those of you who don’t have experience with corporate tax here is a brief primer:

Non-recognition Transactions in Corporate Tax

Generally, when one party transfers property to another party in exchange for cash or property, the transferor is subject to tax on the difference between her amount realized and her basis. Assume that T owns a car. T’s basis in the car is $5,000 and the car’s fair market value is now $12,000. If T transfers her car to XCorp, a US corporation, and, in exchange, XCorp gives T a painting worth $12,000, T has realized a gain of $7000. T must pay tax on the amount of this gain.

Now assume that instead of the painting, XCorp transfers $12,000 worth of XCorp to stock T. Once again, T has received property valued at $12,000 for a car with a basis of $5,000, BUT Section 351 of the tax code permits T not to be subject to tax on this gain at the time of the transfer. So even though T has a “Realized Gain” of $7000 (i.e. the FMV of the amount realized is $7000 more than T’s basis in the property), T does not have “Recognized Gain” (i.e. T is not subject to tax on the gain). The reason for this Non-recognition treatment is that T continues to own the car indirectly through XCorp. Since T received XCorp stock, T is now a shareholder of XCorp which owns the car. Although T does not recognize gain, T’s basis in the XCorp remains at $5,000. So if XCorp stock did not appreciate and T sold the XCorp stock in one year, T would have to recognize $7,000 at that time. Meanwhile, XCorp’s basis in the car is also $5,000. So if XCorp sold the car, XCorp would have Recognized Gain of $7,000 at that time.

This non-recognition treatment is permitted for various transactions in corporate tax such as mergers, spin-offs and liquidations. The logic is that these transactions do not change the ownership of the property by T, only the manner in which T owns the property (i.e. indirectly through another entity rather than directly).

International Tax Implications

The problem occurs when the transferee corporation is a foreign corporation rather than a US corporation. So if XCorp is a foreign corporation instead of a US corporation, it is not enough to rely on the non-recognition treatment provided by Section 351. We must now consider the implications of Section 367.

As we saw above, when XCorp is a US corporation, taxation of the gain is deferred until such time as T sells the XCorp shares or XCorp sells the car. However, if XCorp was a foreign corporation, XCorp would be beyond the jurisdiction of the US. Hence, when T transfers the car to XCorp, she is in fact transferring the property outside the US’s jurisdiction. Even though T still owns the car indirectly through XCorp, the IRS believes it is necessary to disallow deferment of the gain because the property moves beyond the US’s jurisdiction.

So the rules are as follows:

1- Section 351 operates to allow for non-recognition when a taxpayer transfers property to a corporation in exchange for the corporation’s stock.

2- When the transferee corporation is a Foreign Corporation, Section 367 trumps Section 351 and gain must be recognized upon the transfer of the property.

Exceptions to Section 367: Active Trade/Business

If the assets that are transferred to the foreign corporation are used by that corporation in an Active Trade/Business, then Section 367 does not apply. As a result, non-recognition (under Section 351) is permitted when the assets that are transferred are used in an Active Trade/Business.

Exception to the Exception

Tainted Assets

Even if the foreign corporation is using the assets in an active trade/business, gain must nonetheless be recognized for the following assets:

Accounts Receivable

Inventory

Intangible Assets

The Active Trade/Business exception applies to all other assets such as Equipment, Real Property and Goodwill.

Depreciation Recapture Rule

Even if a transferred asset is used in an Active Trade/Business and the asset is NOT a tainted asset, gain must be recognized to the extent depreciation was taken on the asset against US income (this should remind you of the sourcing rule regarding depreciable personal property that we discussed in week 2). Consider the following example:

T buys an airplane for $500,000. She depreciates the plane to zero (so her basis in the plane is now zero). When the plane has a value of $700,000 she transfers it to ForCo, a foreign corporation, in exchange for stock in ForCo. ForCo will use the plane in an air-taxi business.

The Active Trade/Business exception applies since the asset will be used in an active business by ForCo. There is $700,000 of Realized Gain. However, $500,000 of that gain must be recognized (T must pay taxes on it) since $500,000 of depreciation was taken against US income. The remaining $200,000 of Realized Gain need not be recognized. So T’s basis in the ForCo stock will be $500,000. The $200,000 of built-in gain (difference between T’s basis in ForCo stock and the Fair Market Value) won’t be recognized until T sells the ForCo stock.

Branch Loss Recapture Rule

If the transferred assets are part of a branch operation that has sustained a net loss at the time of the transfer, gain on those assets must be recognized at the time of the transfer. The objective is to prevent taxpayers from operating as a branch during the early period of a new business when it sustains losses and then transferring the branch assets to an offshore corporation just before the operation becomes profitable. The theory is that if the start-up’s losses offset US income, then the recapture of those losses must be recognized when the assets of the operation are transferred outside the US.

Assume that T operates a new start-up and the operation sustains losses in 2001 of $12,000 and losses in 2002 of $5,000. If T transfers the assets of the operation to a foreign corporation in 2003, then, to the extent that the assets produce $17,000 of realized gain, such gain must be recognized at the time of transfer.

Now assume instead that in 2002 the operation made a profit of $14,000 instead of a loss of $5,000. Here there is a net gain (of $2,000) at the time of the transfer so no gain must be recognized.

Transfers of Stock and Intangible Assets

The Section 367 rabbit hole runs quite deep and we’ve only touched the surface. We have not discussed the consequences of transferring stock or intangible property to foreign corporations. Such transfers are subject to another set of rules and the discussion of those rules could be an entire course in itself.

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