International Accounting, T. Doupnik Ch 10

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Foreign branch

Back 1

- not a legal corporate entity separate from the foreign company
- merely an extension of the parent company; it does not have its own stock or its own board of directors, and its establishment generally involves fewer corporate formalities. However, in practice, filing a branch is a demanding process that requires the execution of formal duties and the translation of documents, which in some cases may represent a bigger constraint than those applicable to incorporating a company.

- considered as a tax resident for US.

Advantage to register the foreign operation as a branch: any losses are currently deductible on the US tax return.
Disadvantage: any profits are taxed currently in the US.

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The subsidiary

Back 2

- will have its own stock, articles of incorporation and bylaws;
- must hold shareholders' meetings and observe other corporate formalities.
- will be owned and controlled by the parent company.

- not considered as a tax resident for US
Advantage: US income taxes are deferred until profits are repatriated back to the US through the payment of dividends.
Disadvantage: net loss of subsidiary may be not deductible on the US parent's tax return.
That why MNC initially set up there foreign operations as a branch, when losses are expected, and then in a few years incorporated it as subsidiarity, when operations become profitable. (as a sale of branch to subsidiary, but will need to pay tax on a gain from sale)

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MNC's Methods of financing there foreign operations

Back 3

debt (through loans) or equity (capital contributions),
- affected by the rules governing taxation of interest and dividends in the host country
-usually companies prefer to finance with as much debt and as little equity as possible (thin capitalization), because:
1. a lower withholding tax rate on interest than on dividends
2. interest payment are generally tax deductible, but dividends payments are not

Front 4

ways of Repatriation back to MNC

Back 4

dividends pmnts (on equity financing)
interest payments (on debt financing)

Front 5

Type of taxes / Corporate income taxes

Back 5

direct taxes on business income
- tax rate and way of calculation is different across countries
-MNC should consider both local and national taxes
-in some countries can depend on type of activities or the nationalities of the companies owner
- effected by competition between countries in attracting foreign investment.

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Tax havens

Back 6

tax jurisdictions with abnormally low corporate income tax rate (or no corporate tax at all)
OECD criteria:
- no or only nominal effective tax rates
-lack of effective exchange of information
-lack of transparency
-absence of substantial activities requirement.

Front 7

withholding taxes

Back 7

taxes on dividends and some other amounts paid to foreign citizens (interest and royalties).
in US - 30%
many countries have a lower rate of withholding tax on interest than on dividends.

Front 8

thin capitalization

Back 8

a way of financing foreign operations, when companies prefer to finance with as much debt and as little equity as possible, because:
1. a lower withholding tax rate on interest than on dividends
2. interest payment are generally tax deductible, but dividends payments are not.
some countries set limits of min capitalization (ratio of debt to equity limitation, if more - not deductible)

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thin capitalization

Back 9

Heavy debt financing, when companies prefer to finance with as much debt and as little equity as possible, because:
1. a lower withholding tax rate on interest than on dividends
2. interest payment are generally tax deductible, but dividends payments are not.
some countries set limits of min capitalization (ratio of debt to equity limitation, if more - not deductible)

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Value-added tax

Back 10

A substitute for sales taxes.
These taxes are added into the price of the product or service at each stage.
The U.S. does not have value-added tax, but it is common in the the EU.
It is also used in Australia, Canada, China, Hungary, Mexico, Nigeria, Turkey, and South Africa.

Front 11

Double taxation

Back 11

When two countries tax the same income, this is referred to as double taxation.
This occurs when one country taxes the income earned by a foreign company in that country, and the same company’s home government taxes its foreign source income.
Overlapping jurisdictions give rise to double taxation, and can even result in triple taxation.
To alleviate double taxation in these cases, the country of residence generally defers to the country where the income was earned.
In other words, source takes precedence over residence.

Solutions to double taxation:
- One solution is for a country to adopt the territorial approach, exempting foreign source income from taxation.
- Another solution is for a country to allow domestic companies to deduct taxes paid to foreign governments.
- A third solution is for a country to provide a tax credit to domestic companies for taxes paid to foreign governments.
Most countries, including the U.S., use the deduction and credit approaches.

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Taxation jurisdiction approaches//
Worldwide (nationality) approach

Back 12

all income of a resident or company incorporated in a country is taxed by that country (on the basis of nationality/residence), regardless of where it is earned (imposed on a worldwide income).
- exercised by most countries.

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Taxation jurisdiction approaches//
Territorial approach

Back 13

only income earned in that country is taxed (domestic source income).
the few country use this approach (including France!), and # decreases.

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Basis for taxation

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The three most common bases for taxation are source, citizenship, and residence.
US - all 3
Almost all countries tax income earned within their borders--that is, at its source.
The citizenship basis taxes income of the country’s citizens regardless of source or where they reside.
The residence basis taxes income of the country’s residents regardless of source or citizenship.
-- in US foreign subsidiary of US parent - not a US resident, but a foreign branch is!
- under worldwide approach for taxation US parent pays US income tax currently on foreign branch income, but foreign subsidiary income is not taxed in the US until dividends are paid to the US parent.

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FTC (Foreign Tax Credit)– The U.S. approach

Back 15

The Internal Revenue Service (IRS) allows companies one of two options.
- One is to deduct all foreign taxes paid.
-The other is to receive a tax credit for all foreign !! income !! taxes paid (incl withholding tax, but exclud. sales and other not income based tax!!!!)
- FTC has more advantages than deduction

The U.S. will not allow the credit to exceed the FTC limitation.
The FTC allowed is equal to lower of
1. actual taxes paid to a foreign government.
2. the taxes that would have been paid if the income was earned in the U.S. (35% tax rate) = overall FTC limitation!!!

Excess FTC (difference between FT paid and FTC limitation) can be carried back one year or carried forward ten years.
!!! the excess FTC can be used only if , in the previous year or in the next 10 years, the average foreign tax rate paid by the company is less than US tax rate!!!

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Overall FTC limitation formula

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Overall FTC limitation= Foreign Source Taxable income / Worldwide taxable income (total income of the company) x US taxes before FTC

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FTC baskets

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The Tax Reform Act of 1986 created nine FTC baskets.
These baskets were defined by different types of foreign income.
FTC was calculated separately for each of the nine baskets.
FTC from different baskets could not be netted against one another.
The American Jobs Creation Act of 2004 reduced the number of baskets to two, which reduced the likelihood that excess FTC’s would go unused:
General income
Passive income

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Direct FTC

Back 18

- allowed for foreign income tax payed directly by US taxpayer
- in the case of BRANCH income. when parent company is given a credit for the taxes it paid itself to the foreign gov. (dollar- to -dollar reduction)
- withholding taxes

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Indirect FTC

Back 19

subsidiary foreign income will not be taxed in US untill dividends are payed back to the US parent. When parent will include divident incom in US tax return, it will be allowed an indirect FTC for the foreign taxes payed.
To qualify for indirect FTC, the U.S. parent must own at least 10 percent of the voting stock of the foreign subsidiary.

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Grossed-up dividend

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the amount of income taxable in the US from a foreign subsidiary (before tax amount of dividends)
= the dividends + taxes deemed to have been paid on the income from which the dividend was paid.

Front 21

Tax treaties –

Back 21

bilateral agreements regarding how individuals from one country are taxed on income earned in the other country.
Their purpose is to alleviate double taxation problems.
Reducing double taxation helps facilitate international trade and investment.
Tax treaties also involve information sharing between governments that helps in domestic enforcement.
U.S. tax treaties
The U.S. also has a model tax treaty that serves as a starting point when negotiating tax treaties.
This model has zero percent withholding tax for interest and royalties and 15 percent for dividend payments.
The U.S. has treaties with over 50 countries.
One notable exception is Brazil, primarily due to lack of Brazilian investment in the U.S.
Treaty shopping is a tax reduction tactic, related to treaties, that some countries are trying to stop

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Controlled foreign corporation (CFC)

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A foreign corporation where U.S. shareholders own more than 50 percent of the combined voting power or fair value of the stock
A U.S. shareholder is a U.S. taxpayer that owns at least 10 percent of the stock.
Much CFC income is referred to as Subpart F income.
Unlike the deferral of tax on foreign subsidiaries until receipt of a dividend, Subpart F income is taxable currently.
There is a safe harbor for such income in jurisdictions with tax rate > 90% of the U.S. rate.
- help to avoid tax havens
- ALL majority-owned foreign subsidiaries of US based companies are CDC

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Tax holidays

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an incentive used by a government that partially or completely exempts a taxpayer for a period of time.
Many Asian countries offer tax holidays to foreign companies.
The primary reason for offering tax holidays is to encourage foreign direct investment.
MNEs can enjoy significant tax reductions provided if profits are not repatriated and reinvested in the same country
(because dividends will be taxed in the parent's country and no FTC will be available as no FT were paid)

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Tax Sparing

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FTC granted by some countries, if a company invested in developing country, where they have tax holiday (not by USA)

Front 25

U.S. export incentives

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CFC and Subpart F income provisions prevent some tax avoidance strategies previously used by exporters.
Domestic international sales corporation (DISC) was a short-lived export incentive program for U.S. companies: companies were able to establish export subsidiary in US and a part of the profit earned by DISC could be deferral form taxation until actual distribution to the parent.
Foreign sales corporation (FSC) was another short-lived export incentive program for U.S. companies: portion of an FSC was tax exempt and the rest was taxed currently.
Both of these programs were eventually repealed due to foreign opposition.
The Extraterritorial Income Exclusion Act (ETI) essentially replaced the FSC: add two test to determined who could exclude income from export sales.
- was repleted by AJCA in 2004

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American Jobs Creation Act of 2004 (AJCA)

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The AJCA was an attempt to spur job growth in the U.S. manufacturing sector, broadly defined - much more companies benefits.
The program provides a deduction that effectively reduces income tax rates for domestic manufacturers.
The deduction is available even to companies that don’t export.
In addition, the AJCA contains a provision that significantly reduced tax rate on repatriations of foreign source income of MNC (for 1 year, 85% of div)
- reduced # of baskets
- change the lengths of the carryover periods for excess FTCs

Front 27

Foreign Earned Income Exclusion

Back 27

- max 87,600$ income can be excluded (2008) - even if not taxed my the foreign country
+ for the rest amount - direct FTC on the foreign tax paid is allowed
- if foreign tax rate > US, will pay no additional US tax on foreign tax income
FEIE required:
- have tax home in a foreign country
- meet one of 2 residency tests

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tax home

Back 28

where permanently or indefinably engaged to work + his abode

Front 29

Bona Fide Residence Test

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- not has to be permanent, but going to work for a indefinite or extend period of time and move with a family
- can interned to return to US
must reside for an uninterrupted period, incl tax year
-may leave for brief trips

Front 30

Physical Presence Test

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presence for 330 full days during a consecutive 12-month period

Front 31

Foreign Housing Exclusion

Back 31

- should meet the same 2 requirements as for FEIE
- housing allowance provided by is taxable income in US
-the excess housing cost (actual housing cost greater than 16% of the US gov pay) can be excluded from the US taxable income (not about extravagant expenses)