ACCT 5327
Fall 2009
Class Notes—Exam 3
10/27/2009—Source of Income and Deductions
I. Significance
a. U.S. taxpayers – FTC limitation is equal to U.S. tax on net foreign source income.
b. Foreign taxpayers – U.S. income tax liability is imposed only on net U.S. source income.
II. General Rules for Sourcing Gross Income – source rules depend on type of income:
a. Interest income: general rule is that source is determined by reference to residence of payor.
i. Exceptions:
1. §861(a)(1)(A)—interest paid by U.S. corp is foreign source if >= to 80% of corp’s gross income over prior 3 years is foreign source trade or business income [e.g., an “80:20” corp] (see §861(c)(1)(B) for classification of interest, dividends, rents, and royalties).
2. §861(a)(1)(B)—interest paid by a foreign branch of a U.S. bank is treated as foreign source.
3. §861(c)(2)—interest paid by an “80:20” U.S. corp to a related person (>10%) is allocated between U.S. and foreign source in proportion to payor’s income from U.S. and foreign sources.
4. §884(f)(1)(A)—interest paid by U.S. branch of a foreign corporation is treated as if paid by a domestic corporation.
5. §904(g)(3)—interest paid by a foreign corporation that is at least 50% owned by U.S. shareholders is U.S. source income to the extent attributable to income earned by the foreign corp from U.S. sources.
b. Dividend income: general rule is that dividend income is source by reference to residence of payor.
i. Exceptions:
1. §861(a)(2)(B)—if 25% or more of a foreign corporation’s gross income is effectively connected with the conduct of a U.S. trade or business, its dividends will be deemed U.S. source income to extent attributable to U.S. business income (determined based on percentage of prior 3 years gross income attributable to U.S. vs. foreign income).
2. §904(g)(4)—dividends paid by a foreign corporation that is at least 50% owned by U.S. shareholders are U.S. source income to the extent attributable to income earned by the foreign corp from U.S. sources.
c. Personal Services income: source based on where services are performed.
i. Applies to both current and deferred compensation—e.g. pensions, NSO exercise
ii. Determination of where services are performed can be complex.
d. Rents & Royalties: source based on where property is used.
e. Gain on sale of realty: source based on where property is located.
f. Gain on sale of assets other than real estate:
i. Purchased inventory—source based on where title passes.
ii. Manufactured inventory—source based on independent factory price method or 50:50 method.
1. Independent factory price method—portion of gross income attributable to production activity (sourced to location of production) is based on difference between cost of manufacture and independent factory price at which products are sold. Remainder allocated to sales activity.
2. 50:50 method—half of gross income attributable to production activity (and sourced by reference to location of production) and half attributable to sales activity (sourced by reference to where title changes hands).
iii. Intangible property (e.g. patents, copyrights, etc.)—
1. Contingent proceeds?—treat as royalty.
2. Fixed proceeds?—source based on residence of seller.
iv. Securities—source based on residence of seller.
1. Exceptions:
a. Sale by U.S. resident through foreign office is foreign source if foreign government imposes at least 10% tax on such sale;
b. Sale by nonresident through U.S. office is U.S. source.
v. Depreciable property—
1. Depreciation recapture—source by reference to source of depreciation deductions.
2. Appreciation—source based on where title passes.
g. Sale of stock in foreign affiliate: gain is foreign source if:
i. sale occurs in foreign country in which affiliate is engaged in the active conduct of a trade or business; and
ii. the affiliate derived more than 50% of its gross income during the preceding three years from active conduct of trade or business in such foreign country.
III. Determination of Residence of Taxpayer
a. U.S. residents include:
i. Domestic corporations
ii. U.S. citizen or resident who does not have a tax home in a foreign country
iii. Nonresident aliens who have a tax home in the U.S.
iv. Trust or estate whose situs is in the U.S.
b. All others are nonresidents
c. “Tax Home” is taxpayer’s principal or regular place of business.
IV. Source Rules for Deductions
a. General Approach: taxpayer is allowed deductions for expenses and losses directly related to either U.S. or foreign-source gross income as well as a ratable portion of expenses and losses not directly related to any specific item of gross income.
b. Thus, sourcing deductions is a two-step process:
i. Allocation of expenses/losses between classes of gross income
ii. Apportionment between U.S. and foreign source gross income.
c. Temp. Reg. 1.861-8T(c)(1): Taxpayer must generally choose a “reasonable” basis on which to apportion deductions. Reasonable bases include:
i. Gross income
ii. Gross receipts
iii. Units sold
iv. Cost of goods sold
v. Gross profit
vi. Assets used
vii. Salaries used
viii. Space utilized
ix. Time spent
x. Etc.
d. Some types of expenses must be allocated using specialized apportionment rules:
i. Interest expense—apportioned between U.S. and foreign-source income using relative “value” of U.S. and foreign assets. Taxpayer may choose between two valuation methods:
1. Tax book values (i.e., tax basis)
2. Fair market values
ii. Research & Development expenditures—
1. Sales Apportionment method: half allocated to place where R&D expenditures occurred, and half prorated between U.S. and foreign sources according to sales.
2. Gross Income method: one-fourth allocated to place where R&D occurred and remainder prorated between U.S. and foreign sources according to gross income.
10/29/2009 – Foreign Tax Credit
V. Foreign Tax Credit
A. All or none alternative for any one year. §275(a)(4).
B. Taxpayer files new election each year (corporations use Form 1118).
VI. Types of Foreign Tax Credits
A. §901—the direct credit. .
1. Claimed by whoever bears the legal incidence of the tax
2. Include gross foreignsource income
B. §902—the indirect credit ("deemed paid" foreign taxes).
1. Allowed against U.S. tax at the time dividends actually or constructively received
a. Actual receipt
b. Certain income earned by CFCs and FPHCs
2. Computing deemed paid taxes:
Foreign taxes of CFC / X / Dividend received from CFCE&P of CFC (after taxes and before dividend)
3. Indirect credit requires "grossup" approach. §78.
VII. Foreign Tax Credit Limitations. §904 and Reg. §1.9044 through 6.
A. Overall limitation
Total foreignsource taxable incomeTotal taxable income from all sources / X / U.S. income tax before FTC
B. §904(d)—Separate overall limit for certain types of income (look-through rules applied to CFCs):
1. Passive income
2. Other (operating) income
C. §904(f)—Recapture of foreign losses.
1. Foreign losses that reduce U.S.-source income for U.S. income tax purposes are recaptured in subsequent profit years by conversion of the profit from foreignsource to U.S.source income
2. §904(f)(1)—Amount of recapture is equal to lesser of:
a. The amount of the overall foreign loss, or
b. 50% of the taxpayer's foreignsource income for tax year unless taxpayer elects to recapture a greater amount
3. Indefinite carryover of unrecaptured overall foreign losses
D. §904(f)(5)(D)—U.S. losses:
1. Allocated among foreign income in different baskets on proportionate basis
2. Applies after allocation of any foreign losses and before foreign loss recharacterization rule
E. §904(c)—2 year carryback and 5 year carryforward (FIFO).
F. §986—Taxes paid in foreign currency translated at average exchange rate for year of accrual.
11/03/2009 – Branch v. Subsidiary Operations
[NOTE: We did not discuss item IV. in class or otherwise]
VIII. U.S. taxation of foreign companies doing business in U.S.
a. General Framework:
i. U.S. source non-business income—gross income is taxed at flat rate of 30%. Tax must be withheld by payor.
1. Income tax treaties usually reduce tax rate on U.S. source interest, dividends and royalties to 15% or less.
2. U.S. source portfolio income is generally exempt from taxation. [§§871(h) and 881(c)]
3. Capital gains, other than those realized on real estate transactions, also usually excluded from taxation. [Reg. §1.1441-2(a)(3)]
ii. U.S. source trade or business profits—net taxable income taxed at regular corporate tax rates. Branch profits tax imposed when profits repatriated to home country. [§884]
b. Branch Profits Tax:
i. Purpose is to equate the taxation of branch operations of a foreign corporation with those of a U.S. subsidiary of a foreign corporation.
ii. Issue is taxation of shareholders on receipt of dividends.
iii. Tax is equal to 30% of “dividend equivalent amount” (subject to treaty reductions)
c. Dividend Equivalent Amount:
i. Computed by reference to change in branch’s “net equity” amount during the year—reduction in net equity is deemed equivalent to a dividend.
ii. “Net equity amount” is equal to aggregate of money plus the adjusted basis of property used by the branch, less the amount of liabilities “connected with” the U.S. trade or business activities of the branch.
iii. Liabilities connected with the branch’s U.S. operations are apportioned using same approach used to apportion interest expense, except that asset values are determined at year end, rather than as average over the year.
iv. Dividend equivalent cannot exceed accumulated earnings and profits of the branch.
d. Branch Interest—interest paid by a U.S. branch of a foreign corporation is treated as U.S. source income to the recipient. Thus, it is subject to withholding tax at 30%.
[Class discussion started here]
IX. Taxation of U.S. branch operations vs. foreign subsidiaries of U.S. corporation
a. Branch operations consolidated with U.S. parent. Income and deductions apportioned between U.S. and foreign source and foreign tax credit deducted against U.S. tax liability, as illustrated in prior examples.
b. Subsidiary operations are not subject to U.S. taxation until such time as earnings are repatriated to U.S. parent in form of dividend. Dividend is “grossed up” for foreign taxes paid, and foreign tax credit is allowed. No dividends received deduction available as dividend is received from a foreign, rather than a domestic, corporation.
11/10/2009—Transfer Pricing
Section 482 Regs
X. Section 482 Regs
A. Five categories of intercompany transactions governed by 482:
1. Sale of tangible products
2. License of intangible assets
3. Provision of management services
4. Loans
5. Leases of property
XI. Sale of Tangible Products
A. Comparable uncontrolled price method—482 looks to prices charged in comparable uncontrolled transactions for comparable goods
1. Does sub (or parent) sell same or similar products to unrelated parties?
2. Can parent (or sub) purchase same or similar products from unrelated parties?
3. Adjustments can be made for following types of differences:
a. differences in shipping terms
b. differences in warranty obligations
c. minor physical differences between products sold
d. volume discounts (premia)
e. trademark, brand premium, etc. (e.g., Quaker Oats vs. Food Club oat meal)
B. Resale price method—482 looks to the gross profit margins of comparable uncontrolled resellers
1. Appropriate where a manufacturer sells finished products to a controlled distributor who subsequently sells the products to unrelated buyers
2. Method begins with price charged by distributor to unrelated buyers and subtracts appropriate profit margin to arrive at implied transfer price from producer
3. Focus is on the appropriate retail gross profit that should be earned by distributor
C. Cost plus method—482 looks to gross profit margins of comparable uncontrolled producers and then works forward
1. Appropriate where a manufacturer sells unfinished products to a controlled sub that provides further processing before selling finished goods to unrelated buyers
2. Method begins with costs incurred by first producer and adds appropriate profit margin
3. Focus is on the appropriate wholesale gross profit that should be earned by manufacturer
D. Comparable profits method—482 looks to certain profit metrics for similar firms doing business in same geographic region (e.g., United States). Metrics are generally computed over a 3-year period for analysis.
1. Return on capital invested (operating profit/operating assets)
2. Return on sales (operating profit/sales)
3. “Berry” ratio (gross profit/operating expenses)
E. Profit Split Method—under 482 courts have required related entities to split the profits remaining after allocating to each party an appropriate return on their operating costs (e.g., in Eli Lilly, court allowed U.S. parent a return on its marketing costs, allowed P.R. sub a return on its manufacturing costs and “location savings,” and then required a 55:45 split of remaining profits.
1. Comparable profit split method
2. Residual profit split method
11/17/2009—Currency Translation & Currency Transactions
XII. Foreign Currency Translation
A. §985—Companies must account for their operations in their functional currency
a. A U.S. corporation doing business both domestically and through foreign branch operations may have two functional currencies
i. Domestic activities—U.S. dollar
ii. Foreign branch—Foreign currency (if Qualified Business Unit)
b. Qualified Business Unit—conducts a significant part of its business activities in an economic environment in which a foreign currency is used and maintains books and records in that currency.
B. Translation of functional currency is required to file U.S. income tax return:
a. Foreign income taxes translated at the average exchange rate for the taxable year to which the taxes relate (for accrual method t/ps)
b. Foreign-source taxable income translated at the average exchange rate for the taxable year in which income is earned
c. Remittances to U.S. home office are translated into dollars using the spot rate for the date of remittance.
d. Gain or loss must be recognized to extent dollar value of remittance does not equal amount recognized as income when remitted income was included on taxpayer’s U.S. income tax return.
C. CFCs follow same basic procedure:
a. Income of CFC is maintained in functional currency—translation not required.
b. Foreign income taxes translated into dollars using average exchange rate for applicable year.
c. Dividends to U.S. parent translated using spot rate for date of dividend.