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Chapter 11:
International
Taxation
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Learning Objectives
 Describe differences in corporate income tax and
withholding tax regimes across countries
 Explain how overlapping tax jurisdictions cause double
taxation
 Show how foreign tax credits reduce the incidence of
double taxation
 Demonstrate how rules related to controlled foreign
corporations, subpart F income, and foreign tax credit
baskets affect U.S. taxation of foreign source income
11-2
Learning Objectives
 Describe some of the benefits provided by tax treaties
 Explain and demonstrate procedures for translating
foreign currency amounts for tax purposes
 Describe tax incentives provided by countries to attract
foreign direct investment and stimulate exports
11-3
Impact of Taxes—International Business Decisions
 Impact of Taxes
 International location decisions
 Legal form of operation
 Method of financing
11-4
Types of Taxes and Tax Rates
 Types of taxes
 Corporate income taxes
 Imposed by governments
 Tax rates vary
 Zero percent in tax havens
 Over forty percent
 Withholding taxes
 Taxes on dividends
 Other amounts paid to foreign citizens
11-5
Corporate Income Tax
 Corporate income tax rates
 Significant variation worldwide
 Provides tax planning opportunity
 Basis of taxability
 Type of activity
 Nationality of the company owners
 Variation in
 Methods of calculating taxable income
 Differences
 Deductibility of expenses
11-6
Corporate Income Tax
 Tax Haven
 Abnormally low corporate income tax rates
 No corporate income tax at all
 Minimum worldwide income taxes
 Bahamas and the Isle of Man
 No corporate income tax
 Liechtenstein
 Tax rates from 7.5 percent to 15 percent
11-7
Withholding Tax Regimes
 Application to
 Dividends
 Interest
 Royalties
 Vary across countries
 Type of payment
 Recipient
 Impacts tax planning
 Tax-planning strategy
 Thin capitalization
11-8
Value-added tax
 Substitute for sales taxes
 Added into
 Price of product
 Price of service
 At each stage of
 Production
 Distribution
 Used in Australia, Canada, China, Mexico, Nigeria,
Turkey, and South Africa
11-9
Tax Jurisdiction
 Taxation approaches
 Worldwide (nationality) approach
 Tax on all income of
 Resident
 Company of a country
 Regardless of place of earning
 Territorial approach
 Tax only on
 Income earned in that country
 Common approach
 The worldwide approach
11-10
Tax Jurisdiction
 Basis for taxation
 Source
 Followed by most of countries
 Citizenship
 Taxes citizens regardless of
 Source
 Residence
 Residence
 Taxes residents regardless of
 Source
 Citizenship
11-11
Tax Jurisdiction
 Basis for taxation – The U.S. approach
 The basis of U.S. taxes
 Source
 Citizenship
 Residence
 Green card test
 U.S. taxes
 Foreign branch
 Includes income in U.S. parent
 Not foreign subsidiary
 Only dividend paid taxed
11-12
Double taxation
 Same income taxed
 In a foreign country and
 Country of residence
 Discourages
 Capital-export neutrality
 Mechanisms for elimination
 Bilateral tax treaties
 Foreign tax credits
11-13
Double taxation
 Solutions
 Adoption of territorial approach
 Exemption of foreign source income
 Deduction of taxes
 By parent company
 Paid to foreign governments
 Tax credit
 To parent company
 For tax paid to foreign governments
 U.S. allows
 Deduction of taxes
 Credit approach
11-14
Double taxation
 FTC – Example
 Assume : GCO, a U.S. company has a branch in Mexico
where 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
11-15
Double taxation
 FTC – Example







Foreign source income
Deduction for all taxes paid
U.S. taxable income
U.S tax before tax credit
Foreign tax credit
Net U.S. tax liability
Deduction
$50,000
$36,500
$13,500
$4,725
$
0
$ 4,725
Credit
$50,000
$
0
$50,000
$17,500
$16,500
$ 1,000
11-16
Calculation of Foreign Tax Credit
 Complex calculation in U.S.
 FTC is lower of
 Actual taxes paid to foreign government
 Taxes if the income earned in U.S.
 Maximum FTC
 Taxes if the income earned in U.S.
 Overall FTC limit =
before FTC
 Excess FTC
Foreign sorce taxable income
Worldwide taxable income
×U.S. taxes
 Carried back one year
 Carried forward ten years
11-17
FTC baskets
 Created by Tax Reform Act of 1986
 Nine FTC baskets
 Foreign source income
 FTC calculated separately for each
 Netting FTCs across baskets—not allowed
 Excess FTC allowed to be
 Carried back
 Carried forward
 Offset additional taxes paid on income basket
 Reduction of number of baskets to two
 General income
 Passive income
 Reduced likelihood of excess FTC’s going unused
 Reduction by The American Jobs Creation Act of 2004
11-18
Indirect FTC (for subsidiaries)
 Indirect FTC
 Allowed by U.S.
 On foreign taxes
 Paid by foreign subsidiary
 U.S. parent company
 Before-tax amount of dividend
 Qualification for indirect FTC
 U.S. company
 Minimum 10% of voting stock
 Foreign company
11-19
Controlled Foreign Corporations
 Controlled Foreign Corporations
 Foreign corporation
 U.S. shareholder
 Owning at least 10 percent of the stock
 U.S. shareholders own more than 50% of
 Combined voting power
 Or fair value of the stock
 CFC income
 Referred as Subpart F income
 Taxable currently
 There is a safe harbor for such income in jurisdictions with
tax rate > 90% of the U.S. rate
11-20
Subpart F Income
 Income from
 Insurance of U.S. risks
 Countries engaged in international boycotts
 Certain illegal payments
 Foreign base company income
 Amount of Subpart F income taxable
 Less than 5% of total income
 No income taxable
 Between 5% to 70 % of total income
 Proportion of Subpart F income to total is taxable
 Greater than 70 % of total income
 100% of the CFC’s income taxed currently
11-21
Summary of foreign source income taxation
 To determine foreign income
 Factors considered




Legal form of the foreign operation
Operation qualify as CFC
Location in tax haven
Income qualifies as Subpart F income
11-22
Tax Treaties
 Bilateral agreements
 Tax on individuals of one country
 Income earned in other country




Alleviate double taxation problems
Facilitate international trade and investment
Information sharing between governments
Helps in domestic enforcement
11-23
Model treaties
 OECD model treaty
 Basis for most bilateral treaties of developed countries
 Tax if permanent establishment
 In the country
 Recommends reduction of withholding tax rates
 Recommended withholding tax rates




5% of direct investment dividends
15% of portfolio dividends
10% of interest
0% of royalties
11-24
U.S. Tax Treaties
 Zero percent withholding tax
 Interest and royalties
 15 percent
 Dividend payments
 Treaties with over 50 countries
 One notable exception
 Brazil
 Lack of Brazilian investment in the U.S.
 Treaty shopping
 Tax reduction tactic
 Benefit of tax treaty between country
11-25
Translation of foreign branch income
 Net income
 Translated into U.S. dollars
 Use of average exchange rate of the year
 Net income after foreign taxes paid
 Added
 Taxes paid to the foreign government
 Payment date exchange rate
 Grossing up
 Earnings are repatriated to the U.S
 Converted to U.S. dollars
 Difference due to exchange rate
 Foreign exchange gain or loss
11-26
Translation of foreign subsidiary income
 Dividends paid to U.S. parent
 Translated at the spot rate
 On the date of payment
 Added
 Taxes deemed paid on the dividend
 Payment date spot rate
 Grossed up
 Translated deemed taxes paid
 Determines foreign tax credit
11-27
Tax Incentives
 Tax holidays
 Incentive used by a government
 Partially or completely exempts a taxpayer
 A period of time
 Offered by many Asian countries
 Encourages foreign direct investment
 MNEs enjoy significant tax reductions
 If profits are not repatriated
11-28
U.S. export incentives
 Prevention of tax avoidance
 CFC and Subpart F income
 Domestic international sales corporation (DISC)
 Short-lived export incentive program
 For U.S. companies
 Repealed due to foreign opposition
 Foreign sales corporation (FSC)
 Short-lived export incentive program
 For U.S. companies
 Replaced by Extraterritorial Income Exclusion Act (ETI)
 Repealed due to foreign opposition
11-29
American Jobs Creation Act of 2004 (AJCA)
 American Jobs Creation Act
 Attempt to spur job growth
 In the U.S. manufacturing sector
 Provides deduction
 Effectively reduces income tax rates
 For domestic manufacturers
 Available even to companies that don’t export
 Allows for significant tax breaks
 On repatriations of foreign source income
11-30
End of Chapter 11
11-31