Saturday, March 26, 2011

Taxation of foreign-source income: current law and options for reform.......................................................... According to the U.S. Treasury Department, offshore tax deferral will cost the federal government approximately $213 billion over the next five years. A recent Congressional Research Service (CRS) report identified it as the third largest corporate tax expenditure. See Treasury's “General Explanations of the Administration's Fiscal Year 2012 Revenue Proposals” (colloquially referred to as the Green Book). See JCX-19-11, “Estimated Budget Effects Of The Revenue Provisions Contained In The President's Fiscal Year 2012 Budget Proposal.” Taxation of foreign-source income. U.S. corporations are generally taxable on income from outside the U.S. just as they are on income from inside the U.S. ( Code Sec. 862 ) Thus, a U.S. corporation that receives foreign-source income from a low-tax country shouldn't have any tax advantage by virtue of the low rates because all income, whether U.S. or foreign source, is taxed at the same U.S. rate. However, a foreign corporation with U.S. owners can often earn and accumulate income (other than certain types of passive income) at tax rates below the U.S. rate. This is because, subject to certain limitations applicable to controlled foreign corporations (CFCs, see Code Sec. 951 ), the foreign-source income is insulated from U.S. tax until it is actually brought back to the U.S. (i.e., repatriated and distributed to the U.S. owners), at which point it is income to the U.S. owners. In addition, the U.S. corporation is currently allowed to deduct interest associated with the foreign assets under Code Sec. 163, even though its not currently paying U.S. taxes on the income produced by those assets. Opportunity for deferral. Current law provides U.S. corporations with an opportunity to defer income—by, for example, forming a wholly-owned foreign subsidiary in a low-tax country. Under existing rules, the profits that the foreign subsidiary earns are subject to the foreign country's tax, but not to U.S. tax (other than subpart F income under Code Sec. 952 subject to the CFC rules). The U.S. corporation won't pay any U.S. tax on the subsidiary's profits unless and until they come to the U.S., likely via a dividend. It will also receive a foreign tax credit (FTC, explained below) for the amount of tax that it paid to the foreign country. Thus, under current law, there is essentially no “cost” for the deferral. The result is different, however, if the U.S. corporation forms a branch in the foreign country. Since the branch isn't separately incorporated in the foreign country, the U.S. corporation is taxed on the branch's profits when they are earned. The foreign tax credit. Instead of claiming a deduction for foreign taxes paid, a taxpayer may elect under Code Sec. 901 to claim a credit for foreign income taxes paid or deemed paid (discussed below). The credit is intended to mitigate the potential for double taxation. Code Sec. 904(a) limits a taxpayer's FTC to an amount equal to the pre-credit U.S. tax on the taxpayer's foreign source income. Under Code Sec. 904(d)(1) , this limitation is applied separately to “passive category income” (i.e., passive income and other types of specified income such as dividends from a domestic international sales corporation) and “general category income” (i.e., all other types). According to the Treasury Department's “General Explanations of the Administration's Fiscal Year 2012 Revenue Proposals,” the reduction to two foreign tax credit limitation categories (i.e., one for passive category income and one for general category income) by the American Jobs Creation Act of 2004 made it easier for U.S. taxpayers to reduce or eliminate the U.S. tax due on foreign-source income by cross-crediting (discussed below). Under prior law, the limitation was applied separately to nine different categories of income. A U.S. corporation that owns 10% or more of the voting stock in a foreign corporation when it receives dividends from it may, in addition to claiming a credit for foreign income taxes that it pays directly, claim a credit for a foreign corporation's foreign income taxes that the U.S. corporation is deemed to have paid under Code Sec. 902 . The “deemed paid” credit amount is equal to the foreign corporation's accumulated post-'86 foreign taxes multiplied by a fraction, the numerator of which is the amount of the dividend received by the U.S. corporation and the denominator of which is the amount of the foreign corporation's post-'86 undistributed earnings. If a U.S. corporation receives dividends from more than one foreign corporation, the deemed paid taxes are computed separately for each foreign corporation. Cross-crediting. “Cross-crediting” refers to when a U.S. corporation uses excess credits (i.e., those that arise from paying a foreign tax that exceeds what the U.S. tax would be and thus exceeds the Code Sec. 904 limitations) from one foreign corporation to offset U.S. tax owed for repatriated income from another foreign corporation. If the foreign corporations are subsidiaries controlled by the U.S. corporation, the U.S. corporation can choose when the subsidiaries declare dividends and use the “deemed paid” FTC to reduce or potentially wipe out any residual U.S. tax liability. A U.S. corporation can choose to have a wholly-owned foreign subsidiary in a high-tax country declare a dividend. Because of the U.S. corporation's greater-than-10% ownership in the subsidiary, it gets a credit for the “deemed paid” taxes. This can generate an FTC that intentionally exceeds what the U.S. tax would have been if the income had been U.S-source, and this excess credit can be used to reduce the U.S. taxes owed by the U.S. corporation on other foreign-source income. This result is arguably inconsistent with the FTC's intent of simply preventing double taxation. President Obama's 2012 Budget proposals. The President's “Green Book” for 2012 carries detailed international tax proposals, including the following: ... Effective for tax years beginning after Dec. 31, 2011, U.S. corporations would not be able to claim a deduction for an interest expense that is allocated and apportioned to foreign assets unless the foreign-source income stemming from those assets is currently subject to U.S. tax. This proposal would effectively eliminate the “mismatch” that allows U.S. corporations to receive a current benefit from deductions while deferring the associated tax burden. Thus, the interest expense would be deferred and deducted in a subsequent tax year in proportion to the amount of the previously deferred foreign-source income that is subject to U.S. tax. ... Also effective for tax years beginning after Dec. 31, 2011, a U.S. corporation's “deemed paid” credit would be computed based on the aggregate E&P of all of its foreign subsidiaries for which it can claim a deemed FTC, instead of determined separately. This would reduce a U.S. corporation's ability to manipulate the credit. Projected revenue effects. In the “Estimated Budget Effects Of The Revenue Provisions Contained In The President's Fiscal Year 2012 Budget Proposal” (JCX-19-11), released by the Joint Committee on Taxation (JCT) on March 17, the JCT projected that deferring interest expense deductions stemming from deferred income would yield $1,957 million in 2012, and a total of $42,666 million from 2011–2021. The proposal to determine a corporation's FTC on a pooled basis would yield $2,668 million in 2012, with a total of $53,149 million over the 2011–2021 period. The Fiscal Commission's proposal. In its report entitled “The Moment of Truth,” the Fiscal Commission recommended that the U.S. tax foreign-source income under a “territorial system.” Under such an approach, active foreign-source income earned by foreign subsidiaries or direct foreign operations of U.S. corporations would be exempt from U.S. tax. (The taxation of passive foreign-source income, however, would continue to be taxed currently.) Use of the territorial system would presumably remove the disincentives that currently discourage U.S. corporations from repatriating foreign income. Any reform of U.S.'s international tax law would likely be part of a larger tax reform package, and many current proposals involve a reduction in the U.S. corporate tax rate. Such a reduction would presumably lessen (but not eliminate) the incentive to keep corporate income outside of the U.S. Taxation of foreign persons (i.e., nonresident alien individuals and foreign corporations) depends basically on two factors: (1) the source of their income and (2) whether the income is “effectively connected” with a U.S. “trade or business” as those terms are defined in Code Sec. 864(b) , Code Sec. (c) , and Reg §1.864-2 through Reg §1.864-7 . Generally, U.S. source income not effectively connected with a U.S. trade or business is taxed at a flat 30% rate. If the income is connected with a U.S. business, it is taxed at the usual more favorable U.S. graduated rates. Taxpayers can get a credit for foreign income, war profits, and excess profits taxes paid or accrued during the tax year, including such taxes imposed by U.S. possessions. Domestic corporations may also claim a credit for foreign taxes which are paid by a direct or indirect foreign subsidiary and which are deemed paid by the corporation under Code Sec. 902 . Code Sec. 901 . For purposes of the discussion below, income, war profits, and/or excess profits taxes are referred to as “foreign taxes.” Foreign taxes which aren't eligible for the credit may be deducted under Code Sec. 162 or Code Sec. 164 , if the requirements of those IRC sections are otherwise met. Generally, taking the credit is more advantageous than claiming a deduction: the credit can be used to offset a taxpayer's U.S. income tax liability on a dollar-for-dollar basis, whereas a deduction only reduces taxpayer's taxable income; the credit may be taken even if taxpayer does not itemize deductions, so the standard deduction can be claimed in addition to the credit; and the credit may be carried back or carried over where the amount of foreign taxes paid exceeds the credit limit for the tax year. See 888-712-7690

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