Multijurisdictional Taxation Final

Foreign Tax Credit (FTC)

Credit under IRC 901-909 that relieves double taxation when the U.S. taxes worldwide income that a foreign country also taxes; it offsets U.S. tax on foreign source income only.

FTC limitation formula

FTC Limitation = (Foreign Source Taxable Income / Worldwide Taxable Income) x U.S. Tax. Prevents the credit from offsetting U.S. tax on U.S.-source income. Allowable FTC = lesser of foreign taxes paid or the limitation.

Requirements for a creditable foreign tax

(1) Legal and actual foreign tax liability, (2) an income tax or tax in lieu of an income tax, (3) imposed on the taxpayer, and (4) actually paid or accrued.

Noncreditable foreign taxes

VAT, sales taxes, customs duties, and excise taxes do not qualify for the FTC because they are not income taxes.

Taxpayers eligible to claim the FTC (IRC 901(b))

U.S. citizens, U.S. residents (green card or substantial presence test), bona fide residents of Puerto Rico, domestic corporations, and partners/beneficiaries for their proportionate share of entity-paid foreign taxes.

Why nonresident aliens and foreign corporations generally cannot claim the FTC

They are not taxed by the U.S. on foreign source income. Exception: when engaged in a U.S. business, they are taxed on effectively connected income (ECI) - an inbound topic.

FTC baskets

Separate limitation categories (general category and passive category) that prevent cross-crediting between high-tax and low-tax income.

FTC credit vs. deduction election

Annual election: claim the credit on Form 1116 or deduct foreign taxes as an itemized deduction on Schedule A. The choice can be made or changed within 10 years of the unextended return due date.

Why income sourcing matters

The FTC can only offset U.S. tax on foreign source income, and foreign persons are taxed by the U.S. only on U.S. source income. Sourcing also affects withholding taxes, treaty benefits, and planning.

Interest income source rule

Sourced by the residence of the payor (borrower). U.S. resident payor = U.S. source; foreign resident payor = foreign source, even if the payor is a U.S. citizen living abroad.

Dividend income source rule

Source follows the residence of the paying corporation: U.S. corporation = U.S. source; foreign corporation = generally foreign source.

Personal services source rule

Sourced where the services are physically performed; customer location, place of contracting, and place of payment are irrelevant. Employee compensation is allocated on a time basis.

Royalty source rule

Sourced where the intangible is used, not where it was developed. Software licensed for use in Germany = foreign source royalty.

Rent and inventory source rules

Rental income is sourced by the location of the rented property. Inventory sale income is generally sourced where title passes.

Why was Subpart F implemented (1962)?

Before 1962, U.S. taxpayers used foreign corporations in low-tax countries to indefinitely defer U.S. tax on passive and mobile income. Subpart F eliminates inappropriate deferral by taxing U.S. shareholders currently on specified categories of CFC income, even with no dividend, while allowing deferral for active foreign business income.

Controlled Foreign Corporation (CFC)

A foreign corporation in which U.S. shareholders collectively own more than 50 percent of the vote or value of the stock.

U.S. shareholder (Subpart F)

A U.S. person owning at least 10 percent of the foreign corporation's vote or value.

Foreign Personal Holding Company Income (FPHCI)

The passive income category of Subpart F: interest, dividends, royalties, rents, annuities, and net gains from certain property transactions.

Foreign Base Company Sales Income (FBCSI)

Subpart F income arising when a CFC buys from or sells to a related party and the goods are both manufactured and used outside the CFC's country of incorporation.

Foreign Base Company Services Income (FBCSvI)

Subpart F income when a CFC performs services for or on behalf of a related party outside the CFC's country of organization.

Why was GILTI enacted (TCJA 2017)?

Congress believed multinationals were still shifting highly profitable active income - especially IP like software, patents, and brands - to low-tax jurisdictions despite Subpart F. GILTI requires current inclusion of CFC earnings that exceed a routine return on tangible business assets.

GILTI calculation (simplified)

GILTI = Tested income minus routine return, where routine return = 10 percent of QBAI. Example: 22M tested income - 6M routine return (10 percent of 60M QBAI) = 16M GILTI.

Qualified Business Asset Investment (QBAI)

The average adjusted basis of depreciable tangible property used to produce tested income - equipment, buildings, machinery, production facilities. Central to computing the routine return.

Tested income (GILTI)

Active foreign business income (manufacturing, distribution, services) of a CFC, excluding Subpart F income, effectively connected income, high-taxed income, and certain dividends.

GILTI and foreign tax credits

Corporate U.S. shareholders may credit a portion of foreign taxes on GILTI, subject to limitations. High-tax jurisdictions produce little or no residual U.S. tax; low-tax jurisdictions produce greater U.S. tax exposure.

Subpart F vs. GILTI

Subpart F (1962) targets specific categories of passive/mobile income to prevent deferral; GILTI (2017) is a broad residual regime taxing active foreign earnings above a routine return on tangible assets (QBAI). They are complementary anti-deferral regimes.

Section 482

Gives the IRS authority to reallocate income and deductions among related (controlled) parties so intercompany transfer prices reflect an arm's length result.

Arm's length standard

Related-party prices should match what unrelated parties would have negotiated under similar circumstances.

Best method rule

The best transfer pricing method is the one that most reliably reflects the transaction that would have been made by unrelated parties; no single method is automatically required.

Comparable Uncontrolled Price (CUP) method

Compares the actual price in a controlled (related-party) transaction to the price in a comparable transaction between unrelated parties. The most direct method, preferred by the IRS and OECD when reliable comparables exist.

Internal CUP vs. external CUP

Internal CUP: taxpayer sells the identical product to an unrelated customer (more reliable, preferred when available). External CUP: pricing data from unrelated companies (often requires adjustments).

Transfer pricing method selection hierarchy

Evaluate CUP first; if unreliable, consider Resale Price, then Cost Plus, then TNMM, then Profit Split. Comparability factors: product, functions, contract terms, economic conditions, business strategy.

DEMPE framework

OECD framework allocating intangible profits to the entities performing Development, Enhancement, Maintenance, Protection, and Exploitation functions - not merely to the legal owner of the IP.

Primary objectives of tax treaties

Eliminate double taxation, prevent tax evasion and avoidance, encourage foreign investment, promote international trade, increase certainty for taxpayers, and provide dispute resolution mechanisms.

Individual residency tie-breaker rules (in order)

1) Permanent home, 2) Center of vital interests (most important), 3) Habitual abode, 4) Nationality, 5) Competent authority determination (rare). Applied in sequence when both countries claim the individual as a resident.

Permanent establishment (PE)

A fixed place of business through which the business of an enterprise is wholly or partly carried on (office, factory, branch, mine). Without a PE, the source country generally cannot tax the foreign enterprise's business profits under a treaty.

Saving clause

Provision in U.S. treaties preserving the United States' right to tax its citizens and residents as if the treaty had not entered into effect, subject to specified exceptions.

Limitation on Benefits (LOB)

Anti-treaty-shopping provision denying treaty benefits to shell companies, conduit entities, and artificial structures formed solely to obtain treaty benefits.

Nexus (state taxation)

The degree of business activity that must be present before a state can tax an out-of-state entity's income - e.g., income derived in-state, property owned or leased, employees, or capital located in the state.

Allocation vs. apportionment

Apportionment divides business income among states by formula (traditionally equal-weighted sales, property, and payroll factors); allocation directly assigns nonbusiness income to the state where the income-producing property is located.

Unitary business theory

Treats interdependent affiliated entities as a single combined unit for state apportionment, ignoring separate legal existence. Most unitary states allow a water's edge election limiting the group to U.S. operations.