TAXATION OF FOREIGN-SOURCE INCOME
TAXATION OF FOREIGN-SOURCE INCOME
When a domestic firm makes the decision to sell its products internationally, it can do so directly through the export of goods and services (including licensing agreements, management contracts, and so on), through foreign branch operations (a legal extension of the parent), and through foreign corporations in which the domestic firm holds an equity interest that could vary from a small percentage to complete ownership.
Export of Goods and Services
Many enterprises, such as public accounting firms, advertising agencies, banks, and management consulting firms, deal in services rather than products. Many manufacturing industries also find it easier and more profitable to sell expertise, such as patents or management services, rather than goods. Generally, payment is received in the form of royalties and fees, and this payment usually is taxed by the foreign government. Since the sale of services is made by the parent, the sale also must be included in the parent's taxable income.
Despite the large amount of foreign direct investment, U.S. firms still export a great deal of merchandise. In 1990 this export figure reached $389.3 billion.6 Generally, the profits from these exports are taxable immediately to the parent. However, many governments have created tax incentives to encourage exports.
In order to gain tax advantages from exporting, a U.S. firm can set up a Foreign Sales Corporation (FSC) abroad, according to strict guidelines established by the IRS. If the foreign corporation qualifies as an FSC, a portion of its income is exempt from U.S. corporate income tax. Also, the law provides that any dividends distributed by the FSC to its parent company are exempt from U.S. income taxation as long as that income is foreign trade income.
Certain kinds of economic activity qualify for the FSC legislation: the export of merchandise as well as services such as engineering services or architectural services. Also it is important that substantial economic activity take place outside of the United States. The FSC cannot be a mailbox company in Switzerland that simply passes documents from the United States to the importing country. The FSC must engage in advertising and sales promotion, processing customer orders and arranging for delivery, transportation, the determination and transmittal of a final invoice or statement of account and the receipt of payment, and the assumption of credit risk.7
Foreign Branch
A foreign branch is an extension of the parent rather than an enterprise incorporated in a foreign country, as is a foreign manufacturing subsidiary.
Therefore, any income generated by the branch is taxable immediately to the parent, whether or not cash is remitted. One important aspect of taxation of foreign branch income is that if the branch suffers a loss, the parent is allowed to deduct that loss from its taxable income, thus reducing its overall tax liability. There is no such thing as deferral in the case of a branch, since all income or loss is immediately combined with parent income or loss. Deferral means that foreign-source income generally is not taxed until it is remitted to the parent company.
Foreign Corporations
CFC From a tax standpoint it is critical to determine first of all whether or not the foreign subsidiary or affiliate is a controlled foreign corporation (CFC). A CFC is any foreign corporation in which 50 percent or more of the voting stock or value of the corporation is held by "U.S. shareholders." A U.S. shareholder is a U.S. person or enterprise that holds 10 percent or more of the voting stock of the subsidiary. Table 19.4 explains how this might work.
Foreign corporation A is a CFC because it meets both tests described above. This is the case when A is a wholly owned subsidiary of parent firm V in the United States. Foreign corporation B is also a CFC because U.S. persons V, W, and X are qualified "U.S. shareholders," and their share of the voting stock exceeds 50 percent. Foreign corporation C is not a CFC, because only U.S. persons V and W are qualified "U.S. shareholders," and their combined voting shares do not equal or exceed 50 percent.-
Once a CFC has been identified, its income must be divided into two categories: (1) active income and (2) subpart F, or passive, income. Active income implies that it is income derived from the active conduct of trade or business, whereas passive income usually results from operations in tax-haven countries, such as Panama, the Bahamas, the Netherlands Antilles,
Hong Kong, and Switzerland. In Chapter 9, we discussed the importance of offshore financial centers. Companies established in these centers are often called tax-haven subsidiaries.
The tax-haven subsidiary sometimes has acted as a holding company for its parent of stock in foreign subsidiaries (called grandchild or second-tier subsidiaries, as illustrated in Fig. 19.5), a sales agent or distributor, an agent for the parent in licensing agreements, or an investment company. The tax-haven subsidiary is meant to concentrate cash from the parent's foreign operations into the low-tax country and to use the cash for global expansion. As long as a dividend is not declared to the parent, no U.S. tax must be paid. However, the Revenue Act of 1962 eliminated the deferral concept for tax-haven subsidiaries involved in passive rather than active investments.
Subpart F Income As noted earlier, subpart F income is passive income, because it is not derived from the active conduct of a trade or business, such as manufacturing and selling products at market prices. Subpart F income basically is earned by CFCs in a tax-haven country from activities outside of that country. This type of income comes from the following major sources.
1.
2.
Holding company income: primarily dividends, interest, rents, royalties, and gains on sale of stocks.
Sales income: income from foreign sales subsidiaries that are separately incorporated from their manufacturing operations. The product is either manufactured, produced, grown, or extracted outside of and sold for use
outside of the CFC's country of incorporation. Any CFC performing significant operations on the property is excluded, such as when personnel in the CFC are heavily involved in selling the product.
3. Service income: income from the performance of technical, managerial, or similar services for a related person and performed outside the country in which the CFC is organized.
The importance of distinguishing between a CFC and a non-CFC and subpart F and active income is in the application of the deferral principle, which is summarized in Fig. 19.6. As long as a foreign corporation is not a controlled foreign corporation, its income is not taxable to the parent until a dividend is received by the parent. Thus the income is deferred from taxation in the U.S. If the foreign corporation is a controlled foreign corporation, the deferral principle applies to the active but not to the subpart F income, which is immediately taxable to the parent.
There is an exception, however. If foreign-base company income is the lower of $1 million or 5 percent of gross income, none of it is treated as subpart F income. If foreign-base company income is subject to a tax of at least 90 percent of the U.S. tax liability, the income also is not subject to U.S. tax.
value of the dividend by including the corporate tax that was paid, then pay the tax based on the individual tax rate. However, the shareholder is allowed to take a tax credit equal to what the corporation paid at 36 percent.
Table 19.5 illustrates some of the differences in tax rates among countries, but it is difficult to make a simple comparison. Most of those rates are subject to conditions, such as tax treaties, that will be discussed next. Japan has different tax rates, depending on the amount of capitalization and whether the income is distributed or not. Switzerland has federal tax rates ranging from 3.63 percent to 9.8 percent. However, each canton, or local government, imposes its own income tax, which ranges from 0 percent to 35 percent.8
Different countries also have unique systems for taxing the earnings of the foreign subsidiaries of domestic corporations. Some countries, such as France, use a territorial approach and therefore tax only domestic-source income. Other countries, such as Germany and the United Kingdom, use a global approach; that is, they tax the profits of foreign branches and the dividends received from foreign subsidiaries. The United States is the only country to tax unremitted earnings in the form of subpart F income.
Value-Added Tax
The value-added tax (VAT) has been used since 1967 by most of the countries of Western Europe. The VAT is computed by applying a percentage rate on total sales less any purchases from other business entities. As the name implies, VAT means that each independent company is taxed only on the value added at each stage in the production process. If one company was fully
integrated vertically, the tax rate would apply to its net sales because it owned everything from raw materials to finished product.
The country VAT rates in Europe vary significantly despite efforts toward harmonization by the EC. The VAT does not apply to exports, since the tax is rebated (or returned) to the exporter and thus is not included in the final price to the consumer, which results in an effective stimulus for exports.
Tax Treaties: The Elimination of Double Taxation
The primary purpose of most tax treaties is to prevent international double taxation or to provide remedies when they occur. The United States has active income tax treaties with more than 30 countries. The general pattern for
withholding tax between two treaty countries is to grant reciprocal reductions on dividend withholding and to exempt royalties and sometimes interest payments from any withholding tax.
The United States has a withholding tax of 30 percent for owners of U.S. securities (individuals and corporations) who are from countries with which no tax treaties are in effect. However, interest on portfolio obligations and bank deposit interest are normally exempt from withholding. Where a tax treaty is in effect, the U.S. rate on dividends generally is reduced to 15 percent, and the tax on interest and royalties either is eliminated or reduced to a very low level.
A good example of a tax treaty is one between the United States and Canada. Canadian dividends, interest, and royalties remitted to U.S. citizens and corporations normally are subject to a 25 percent withholding tax rate by the Canadian government, but for U.S. firms they are subject to only 15 percent as a result of the tax treaty between the two countries.
Planning the Tax Function
Since taxes affect both profits and cash flow, they must be considered in the investment as well as the operational decision process. When a U.S. parent decides to set up operations in a foreign country, it can do so through a branch or a foreign subsidiary. If the parent expects the foreign operations to operate at a loss for the initial years of operation, it should operate through a branch, since it can deduct branch losses against the current year's income at the parent's level. As the operations become profitable, the firm should switch to a foreign manufacturing subsidiary. If the deferral principle applies to the subsidiary income, then the income of the subsidiary would not be taxed until a dividend is declared.
Tied in with the initial investment decision as well as with continuing operations is the financing decision. Both debt and equity financing affect taxation. If parent loans are used to finance foreign operations, the repayment of principal is not taxable, but the receipt of interest income is taxable to the parent. Also, the interest expense paid by the subsidiary is generally a busi-
ness expense, which reduces taxable income in the foreign country. Dividends, which are a return to equity capital, are taxable to the parent and are not a deductible business expense to the subsidiary. One reason why international finance subsidiaries are set up outside the United States is to escape withholding tax requirements.
A multinational corporation aiming to maximize its cash flow worldwide should concentrate profits in a tax-haven or at least low-tax countries. This can be accomplished by carefully selecting a low-tax country for the initial investment; setting up tax-haven corporations to receive dividends; and carrying out judicious transfer pricing.
Whenever possible, the parent should utilize the 5 percent rule. If the parent has a profitable operating subsidiary in a relatively low-tax country, it can accumulate subpart F income there without worrying about U.S. taxes as long as that income does not reach 5 percent of total subsidiary income. For example, because of its low-tax status and membership in the EC, Ireland can be used both as a manufacturing center to supply the EC with goods and as a tax-haven corporation. The subpart F income provisions have complicated tax planning, but opportunities still exist.
A judicious use of tax treaties also can be very helpful for corporations. For example, the treaty between the United States and the United Kingdom provides for a 15 percent withholding tax on dividends, whereas the treaties between the United States and the Netherlands and between the Netherlands and the United Kingdom provide for 5 percent withholding taxes under certain circumstances. In addition, the Netherlands does not tax dividends from foreign sources. This policy would allow a U.S. firm to set up a holding company in the Netherlands that would receive dividends from a U.K. subsidiary and remit them to the U.S. parent at a combined withholding tax of only 10 percent rather than 15 percent.
Tax law is very complicated, and a firm needs the counsel of an experienced lawyer. The following is a checklist that can assist a tax manager in proper tax planning.
1. Ask the respective controllers for tax projections that enumerate the items that are non-tax exempt. Likewise, timing differences due to accelerated depreciation, and so on, should be shown.
2. Work out a minimum dividend distribution plan so that at year's end the group of companies can exploit any U.S. tax concessions.
3. Find avenues for bona fide reduction of the taxable profit (accelerated depreciation, inventory write-offs, etc.).
4. Check the local company's tax declarations.
5. Examine the local tax assessments and advise management of the non-deductibility of certain items so that corrective measures can be taken.
6. Verify that unjustified tax assessments are contested.
7. Verify that all relevant papers (tax returns, etc.) and tax receipts (photocopies) are forwarded to the parent company in order to obtain foreign tax credits.
8. Ensure that U.S. management is aware of major changes in local tax legislation so that corporate policy for such matters as future investments, cash flow, dividend remittances, and minimum dividend distribution can be formed accordingly.9
When a domestic firm makes the decision to sell its products internationally, it can do so directly through the export of goods and services (including licensing agreements, management contracts, and so on), through foreign branch operations (a legal extension of the parent), and through foreign corporations in which the domestic firm holds an equity interest that could vary from a small percentage to complete ownership.
Export of Goods and Services
Many enterprises, such as public accounting firms, advertising agencies, banks, and management consulting firms, deal in services rather than products. Many manufacturing industries also find it easier and more profitable to sell expertise, such as patents or management services, rather than goods. Generally, payment is received in the form of royalties and fees, and this payment usually is taxed by the foreign government. Since the sale of services is made by the parent, the sale also must be included in the parent's taxable income.
Despite the large amount of foreign direct investment, U.S. firms still export a great deal of merchandise. In 1990 this export figure reached $389.3 billion.6 Generally, the profits from these exports are taxable immediately to the parent. However, many governments have created tax incentives to encourage exports.
In order to gain tax advantages from exporting, a U.S. firm can set up a Foreign Sales Corporation (FSC) abroad, according to strict guidelines established by the IRS. If the foreign corporation qualifies as an FSC, a portion of its income is exempt from U.S. corporate income tax. Also, the law provides that any dividends distributed by the FSC to its parent company are exempt from U.S. income taxation as long as that income is foreign trade income.
Certain kinds of economic activity qualify for the FSC legislation: the export of merchandise as well as services such as engineering services or architectural services. Also it is important that substantial economic activity take place outside of the United States. The FSC cannot be a mailbox company in Switzerland that simply passes documents from the United States to the importing country. The FSC must engage in advertising and sales promotion, processing customer orders and arranging for delivery, transportation, the determination and transmittal of a final invoice or statement of account and the receipt of payment, and the assumption of credit risk.7
Foreign Branch
A foreign branch is an extension of the parent rather than an enterprise incorporated in a foreign country, as is a foreign manufacturing subsidiary.
Therefore, any income generated by the branch is taxable immediately to the parent, whether or not cash is remitted. One important aspect of taxation of foreign branch income is that if the branch suffers a loss, the parent is allowed to deduct that loss from its taxable income, thus reducing its overall tax liability. There is no such thing as deferral in the case of a branch, since all income or loss is immediately combined with parent income or loss. Deferral means that foreign-source income generally is not taxed until it is remitted to the parent company.
Foreign Corporations
CFC From a tax standpoint it is critical to determine first of all whether or not the foreign subsidiary or affiliate is a controlled foreign corporation (CFC). A CFC is any foreign corporation in which 50 percent or more of the voting stock or value of the corporation is held by "U.S. shareholders." A U.S. shareholder is a U.S. person or enterprise that holds 10 percent or more of the voting stock of the subsidiary. Table 19.4 explains how this might work.
Foreign corporation A is a CFC because it meets both tests described above. This is the case when A is a wholly owned subsidiary of parent firm V in the United States. Foreign corporation B is also a CFC because U.S. persons V, W, and X are qualified "U.S. shareholders," and their share of the voting stock exceeds 50 percent. Foreign corporation C is not a CFC, because only U.S. persons V and W are qualified "U.S. shareholders," and their combined voting shares do not equal or exceed 50 percent.-
Once a CFC has been identified, its income must be divided into two categories: (1) active income and (2) subpart F, or passive, income. Active income implies that it is income derived from the active conduct of trade or business, whereas passive income usually results from operations in tax-haven countries, such as Panama, the Bahamas, the Netherlands Antilles,
Hong Kong, and Switzerland. In Chapter 9, we discussed the importance of offshore financial centers. Companies established in these centers are often called tax-haven subsidiaries.
The tax-haven subsidiary sometimes has acted as a holding company for its parent of stock in foreign subsidiaries (called grandchild or second-tier subsidiaries, as illustrated in Fig. 19.5), a sales agent or distributor, an agent for the parent in licensing agreements, or an investment company. The tax-haven subsidiary is meant to concentrate cash from the parent's foreign operations into the low-tax country and to use the cash for global expansion. As long as a dividend is not declared to the parent, no U.S. tax must be paid. However, the Revenue Act of 1962 eliminated the deferral concept for tax-haven subsidiaries involved in passive rather than active investments.
Subpart F Income As noted earlier, subpart F income is passive income, because it is not derived from the active conduct of a trade or business, such as manufacturing and selling products at market prices. Subpart F income basically is earned by CFCs in a tax-haven country from activities outside of that country. This type of income comes from the following major sources.
1.
2.
Holding company income: primarily dividends, interest, rents, royalties, and gains on sale of stocks.
Sales income: income from foreign sales subsidiaries that are separately incorporated from their manufacturing operations. The product is either manufactured, produced, grown, or extracted outside of and sold for use
outside of the CFC's country of incorporation. Any CFC performing significant operations on the property is excluded, such as when personnel in the CFC are heavily involved in selling the product.
3. Service income: income from the performance of technical, managerial, or similar services for a related person and performed outside the country in which the CFC is organized.
The importance of distinguishing between a CFC and a non-CFC and subpart F and active income is in the application of the deferral principle, which is summarized in Fig. 19.6. As long as a foreign corporation is not a controlled foreign corporation, its income is not taxable to the parent until a dividend is received by the parent. Thus the income is deferred from taxation in the U.S. If the foreign corporation is a controlled foreign corporation, the deferral principle applies to the active but not to the subpart F income, which is immediately taxable to the parent.
There is an exception, however. If foreign-base company income is the lower of $1 million or 5 percent of gross income, none of it is treated as subpart F income. If foreign-base company income is subject to a tax of at least 90 percent of the U.S. tax liability, the income also is not subject to U.S. tax.
value of the dividend by including the corporate tax that was paid, then pay the tax based on the individual tax rate. However, the shareholder is allowed to take a tax credit equal to what the corporation paid at 36 percent.
Table 19.5 illustrates some of the differences in tax rates among countries, but it is difficult to make a simple comparison. Most of those rates are subject to conditions, such as tax treaties, that will be discussed next. Japan has different tax rates, depending on the amount of capitalization and whether the income is distributed or not. Switzerland has federal tax rates ranging from 3.63 percent to 9.8 percent. However, each canton, or local government, imposes its own income tax, which ranges from 0 percent to 35 percent.8
Different countries also have unique systems for taxing the earnings of the foreign subsidiaries of domestic corporations. Some countries, such as France, use a territorial approach and therefore tax only domestic-source income. Other countries, such as Germany and the United Kingdom, use a global approach; that is, they tax the profits of foreign branches and the dividends received from foreign subsidiaries. The United States is the only country to tax unremitted earnings in the form of subpart F income.
Value-Added Tax
The value-added tax (VAT) has been used since 1967 by most of the countries of Western Europe. The VAT is computed by applying a percentage rate on total sales less any purchases from other business entities. As the name implies, VAT means that each independent company is taxed only on the value added at each stage in the production process. If one company was fully
integrated vertically, the tax rate would apply to its net sales because it owned everything from raw materials to finished product.
The country VAT rates in Europe vary significantly despite efforts toward harmonization by the EC. The VAT does not apply to exports, since the tax is rebated (or returned) to the exporter and thus is not included in the final price to the consumer, which results in an effective stimulus for exports.
Tax Treaties: The Elimination of Double Taxation
The primary purpose of most tax treaties is to prevent international double taxation or to provide remedies when they occur. The United States has active income tax treaties with more than 30 countries. The general pattern for
withholding tax between two treaty countries is to grant reciprocal reductions on dividend withholding and to exempt royalties and sometimes interest payments from any withholding tax.
The United States has a withholding tax of 30 percent for owners of U.S. securities (individuals and corporations) who are from countries with which no tax treaties are in effect. However, interest on portfolio obligations and bank deposit interest are normally exempt from withholding. Where a tax treaty is in effect, the U.S. rate on dividends generally is reduced to 15 percent, and the tax on interest and royalties either is eliminated or reduced to a very low level.
A good example of a tax treaty is one between the United States and Canada. Canadian dividends, interest, and royalties remitted to U.S. citizens and corporations normally are subject to a 25 percent withholding tax rate by the Canadian government, but for U.S. firms they are subject to only 15 percent as a result of the tax treaty between the two countries.
Planning the Tax Function
Since taxes affect both profits and cash flow, they must be considered in the investment as well as the operational decision process. When a U.S. parent decides to set up operations in a foreign country, it can do so through a branch or a foreign subsidiary. If the parent expects the foreign operations to operate at a loss for the initial years of operation, it should operate through a branch, since it can deduct branch losses against the current year's income at the parent's level. As the operations become profitable, the firm should switch to a foreign manufacturing subsidiary. If the deferral principle applies to the subsidiary income, then the income of the subsidiary would not be taxed until a dividend is declared.
Tied in with the initial investment decision as well as with continuing operations is the financing decision. Both debt and equity financing affect taxation. If parent loans are used to finance foreign operations, the repayment of principal is not taxable, but the receipt of interest income is taxable to the parent. Also, the interest expense paid by the subsidiary is generally a busi-
ness expense, which reduces taxable income in the foreign country. Dividends, which are a return to equity capital, are taxable to the parent and are not a deductible business expense to the subsidiary. One reason why international finance subsidiaries are set up outside the United States is to escape withholding tax requirements.
A multinational corporation aiming to maximize its cash flow worldwide should concentrate profits in a tax-haven or at least low-tax countries. This can be accomplished by carefully selecting a low-tax country for the initial investment; setting up tax-haven corporations to receive dividends; and carrying out judicious transfer pricing.
Whenever possible, the parent should utilize the 5 percent rule. If the parent has a profitable operating subsidiary in a relatively low-tax country, it can accumulate subpart F income there without worrying about U.S. taxes as long as that income does not reach 5 percent of total subsidiary income. For example, because of its low-tax status and membership in the EC, Ireland can be used both as a manufacturing center to supply the EC with goods and as a tax-haven corporation. The subpart F income provisions have complicated tax planning, but opportunities still exist.
A judicious use of tax treaties also can be very helpful for corporations. For example, the treaty between the United States and the United Kingdom provides for a 15 percent withholding tax on dividends, whereas the treaties between the United States and the Netherlands and between the Netherlands and the United Kingdom provide for 5 percent withholding taxes under certain circumstances. In addition, the Netherlands does not tax dividends from foreign sources. This policy would allow a U.S. firm to set up a holding company in the Netherlands that would receive dividends from a U.K. subsidiary and remit them to the U.S. parent at a combined withholding tax of only 10 percent rather than 15 percent.
Tax law is very complicated, and a firm needs the counsel of an experienced lawyer. The following is a checklist that can assist a tax manager in proper tax planning.
1. Ask the respective controllers for tax projections that enumerate the items that are non-tax exempt. Likewise, timing differences due to accelerated depreciation, and so on, should be shown.
2. Work out a minimum dividend distribution plan so that at year's end the group of companies can exploit any U.S. tax concessions.
3. Find avenues for bona fide reduction of the taxable profit (accelerated depreciation, inventory write-offs, etc.).
4. Check the local company's tax declarations.
5. Examine the local tax assessments and advise management of the non-deductibility of certain items so that corrective measures can be taken.
6. Verify that unjustified tax assessments are contested.
7. Verify that all relevant papers (tax returns, etc.) and tax receipts (photocopies) are forwarded to the parent company in order to obtain foreign tax credits.
8. Ensure that U.S. management is aware of major changes in local tax legislation so that corporate policy for such matters as future investments, cash flow, dividend remittances, and minimum dividend distribution can be formed accordingly.9
Comments
Post a Comment