INTERNATIONAL TAXATION

Chapter 10

McGraw-Hill/Irwin

Copyright 2009 by The McGraw-Hill Companies, Inc. All

International Taxation
Chapter Topics

Taxes and international business decisions

Differences in national corporate tax and withholding tax regimes
Overlapping tax jurisdictions and double taxation
Foreign tax credits
Controlled foreign corporations, Subpart F income, and foreign tax
credit baskets
Tax treaties
Foreign currency translation for tax purposes
Tax incentives
10-2

International Taxation
Learning Objectives
1. Describe differences in corporate income tax and withholding tax
regimes across countries.
2. Explain how overlapping tax jurisdictions cause double taxation.
3. Show how foreign tax credits reduce the incidence of double
taxation.
4. Demonstrate how rules related to controlled foreign corporations,
subpart F income, and foreign tax credit baskets affect U.S.
taxation of foreign source income.

10-3

International Taxation
Learning Objectives
5. Describe some of the benefits provided by tax treaties.
6. Explain and demonstrate procedures for translating foreign
currency amounts for tax purposes.
7. Describe tax incentives provided by countries to attract foreign
direct investment and stimulate exports.

10-4

The Impact of Taxes on

Business Decisions
International
The location of international investments is affected by relative tax
rates in the alternative countries.
The decision about the legal form of the foreign operation, branch
or a corporation, is dependent on differential tax treatments.
Method of financing, debt or equity, is affected by the rules
governing taxation of interest and dividends in the host country.

10-5

Corporate Income Tax and

Withholding
Tax Regimes

Types of Taxes

Corporate income taxes are direct taxes on business income.

These are imposed by most governments.
The tax rates vary from zero percent in tax havens to over forty
percent.
Another type of taxes are withholding taxes.
Withholding taxes are taxes on dividends and some other amounts
paid to foreign citizens.

Learning Objective 1

10-6

Corporate Income Tax and

Withholding
Tax Regimes

Corporate income tax rates

Significant variation in tax rates worldwide provides a distinct tax

planning opportunity.
Some countries tax at different rates based on the type of activity or
nationality of the company owners.
In addition to variation in tax rates, there is also variation in how
taxable income is computed.
Expenses that are deductible in one country are not deductible in
others.

Learning Objective 1

10-7

Corporate Income Tax and

Withholding
Tax Regimes

Corporate income tax rates

Since the mid 1980s, there has been a worldwide trend toward
reduced tax rates.
The U.S. started this trend with many other countries following suit
in order to be competitive in attracting foreign investments.
Tax haven countries take this trend to the extreme with some of
these jurisdictions having zero percent tax rates.
The Organization for Economic Cooperation and Development
(OECD) has established guidelines to mitigate the negative impact
of tax havens.
Learning Objective 1

10-8

Corporate Income Tax and

Withholding
Tax Regimes

Withholding taxes

These taxes typically apply to three types of payments: dividends,

interest, and royalties.
Similar to corporate income taxes, withholding taxes vary across
countries and by type of payment and recipient.
Variation in withholding rates impact on tax planning.
For example, a higher tax rate on dividends than interest payments
would encourage relatively more debt financing and less equity
financing.
Heavy debt financing is referred to as thin capitalization.
Learning Objective 1

10-9

Corporate Income Tax and

Withholding
Tax Regimes

Value-added tax

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.

Learning Objective 1

10-10

Tax Jurisdiction and Double

Taxation
Double taxation
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 companys home
government taxes its foreign source income.
Overlapping jurisdictions give rise to double taxation, and can even
result in triple taxation.

Learning Objective 2

10-11

Tax Jurisdiction and Double

Taxation
Taxation approaches
Worldwide (nationality) approach all income of a resident or
company of a country is taxed by that country, regardless of where
it is earned.
Territorial approach only income earned in that country is taxed.
The worldwide approach is much more common.

Learning Objective 2

10-12

Tax Jurisdiction and Double

Taxation
Basis for taxation
The three most common bases for taxation are source, citizenship,
and residence.
Almost all countries tax income earned within their borders--that is,
at its source.
The citizenship basis taxes income of the countrys citizens
regardless of source or where they reside.
The residence basis taxes income of the countrys residents
regardless of source or citizenship.

Learning Objective 2

10-13

Tax Jurisdiction and Double

Taxation
Basis for taxation The U.S. approach
The U.S. taxes on the basis of source, citizenship, and residence.
Residence is defined by being a permanent resident (green card
test).
In combination with the worldwide approach, this means that a U.S.
permanent resident that does not live in the U.S. is taxed on their
foreign source income.
Residence is also defined by residing in the U.S. for at least 183
days in a year (physical presence test).

Learning Objective 2

10-14

Foreign Tax Credit (FTC)

Background Causes of double taxation
Double taxation usually arises when a company is taxed on income
earned in a foreign country and taxed on that same income by its
country of residence.
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.

Learning Objective 3

10-15

Foreign Tax Credit (FTC)

Background 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.

Learning Objective 3

10-16

Foreign Tax Credit (FTC)

FTC The U.S. approach
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.
Given that the majority of such taxes are income taxes, companies
tend to take the tax credit.

Learning Objective 3

10-17

Foreign Tax Credit (FTC)

FTC Example
Assume that GCO is a U.S. company which has a branch in Mexico
where the corporate income tax rate is 33%.
The U.S. corporate income tax rate is 35%.
GCO has foreign source income in Mexico of $50,000.
GCO pays $16,500 of corporate income tax in Mexico and $20,000
of other taxes.
GCO decides to do a calculation to choose between using taxes
paid in Mexico as a deduction or tax credit.

Learning Objective 3

10-18

Foreign Tax Credit (FTC)

FTC Example
Foreign source income
Deduction for all taxes paid
U.S. taxable income
U.S. income before tax credit
Foreign tax credit
Net U.S. tax liability

Learning Objective 3

Deduction
$50,000
$36,500
$13,500
$ 4,725
$
0
$ 4,725

Credit
$50,000
$
0
$50,000
$17,500
$16,500
$ 1,000

10-19

Foreign Tax Credit (FTC)

FTC Other
The U.S. will not allow the credit to exceed the FTC limitation.
This limitation cannot exceed either actual taxes paid to a foreign
government.
OR the taxes that would have been paid if the income was earned
in the U.S.
Excess FTC can be carried back one year or carried forward ten
years.

Learning Objective 3

10-20

Foreign Tax Credit (FTC)

FTC baskets

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 FTCs
would go unused:
General income
Passive income

Learning Objective 3

10-21

Foreign Tax Credit (FTC)

FTC baskets under TRA 86

Passive income
High withholding tax interest
Financial services income
Shipping and aircraft income
Dividends of domestic international sales corporations (DISCs)
Foreign trade income of a foreign sales corporation (FSC)
Dividends from an FSC
Foreign oil and extraction income
All other income

Learning Objective 3

10-22

Foreign Tax Credit (FTC)

Indirect FTC (for subsidiaries)
The U.S. allows an indirect FTC on foreign taxes paid by a foreign
subsidiary of a U.S. parent.
This FTC is not allowed until the income of the subsidiary is taxed
in the U.S.
The amount of income of a foreign subsidiary that is taxable in the
U.S. is the before tax or grossed-up dividend.
To qualify, the U.S. parent must own at least 10 percent of the
voting stock of the foreign subsidiary.

Learning Objective 3

10-23

Controlled Foreign Corporations,

Subpart F Income, and FTC

Controlled foreign corporation (CFC)

Baskets
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.
Learning Objective 4

10-24

Controlled Foreign Corporations,

Subpart F Income, and FTC

Summary of foreign source income taxation

Baskets
What is the legal form of the foreign operation?
Is the operation a CFC?
Is the operation located in a tax haven?
Does the income qualify as Subpart F income?
The answers to each of these questions affects the determination
of how foreign source income is taxed.

Learning Objective 4

10-25

Tax Treaties
Tax treaties 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.

Learning Objective 5

10-26

Tax Treaties
Model treaties
The OECD model treaty is the basis for most bilateral treaties of
developed countries.
A key part of the OECD model is that host countries only tax
business profits of foreign companies associated with permanent
establishments.
Recommending withholding tax rates is another key part of the
OECD model.
The United Nations model treaty is designed to serve as a basis for
treaties between developed and developing nations.
Learning Objective 5

10-27

Tax Treaties
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.
Learning Objective 5

10-28

Translation of Foreign Operation

Income in a Foreign Currency

Translation of foreign branch income

Net income is translated into U.S. dollars at the average exchange

rate for the year.
Taxes paid to the foreign government, translated at the exchange
rate on the payment date, are then added.
This second step is referred to as grossing up.
When earnings are repatriated to the U.S. and converted to U.S.
dollars, the difference between this amount and the translated net
income is a taxable foreign exchange gain or loss.

Learning Objective 6

10-29

Translation of Foreign Operation

Income in a Foreign Currency

Translation of foreign subsidiary income

Dividends paid to the U.S. parent are translated at the spot rate on
the date of payment.
Taxes deemed paid on the dividend, translated at the spot rate on
the date of payment, are then added, or grossed up.
The translated amount of taxes deemed paid is used to determine
the foreign tax credit.

Learning Objective 6

10-30

Tax Incentives
Tax holidays
The term tax holiday refers to 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 that profits are
not repatriated.

Learning Objective 7

10-31

Tax Incentives
U.S. export incentives
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.
Foreign sales corporation (FSC) was another short-lived export
incentive program for U.S. companies.
Both of these programs were eventually repealed due to foreign
opposition.
The Extraterritorial Income Exclusion Act (ETI) essentially replaced
the FSC.
Learning Objective 7

10-32

Tax Incentives
American Jobs Creation Act of 2004 (AJCA)
The AJCA was an attempt to spur job growth in the U.S.
manufacturing sector, broadly defined.
The program provides a deduction that effectively reduces income
tax rates for domestic manufacturers.
The deduction is available even to companies that dont export.
In addition, the AJCA contains a provision that allows for significant
tax breaks on repatriations of foreign source income.

Learning Objective 7

10-33