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International Taxation
South Texas College of Law Houston
McGovern, Bruce A.

International Tax


Spring 2014

Part I: Introduction and Source Rules

Chapter 1: Introduction and Overview

1) 1A – Background

a) Scope of the Inquiry

i) This course deals with the ways in which the U.S. income tax system applies to transactions that in some respect involve one or more other countries

ii) Taxation of the income of foreign entities and individuals doing business or investing in the United States and the taxation of income earned by U.S. entities and individuals from exporting, licensing, rendering services, engaging in other business activities, or investing outside the United States

2) 1B — Basic Questions: Designing a System for Taxing International Transactions

a) Categories of International Transaction

i) “inbound transactions” foreign person invests or conducts business in the US

ii) “outbound transactions” a US person or corporation investing outside of the US

b) Possible Lines of Analysis

i) Exchange theory – older

(1) Related to the social contract where the reason and measure of taxation are in accordance with the principals of an exchange as between the government and the individual

(2) Has two forms

(a) Cost theory

(b) Benefit theory

ii) Faculty theory – based on the ability to pay (has replaced exchange theory)

3) 1C – Reach of US Tax Jurisdiction: the Role of International Law

a) Jurisdiction to tax

i) The jurisdictional power of a nation to tax the income from international transactions is established in the principles of customary international law

ii) Jurisdiction to tax may be based on one or more factors including:

(1) 1. Nationality, 2. Domicile or residence, 3. Presence or doing business within the country, 4. Location within the country or property or TXN from which income is derived

iii) Rest. 3d. of foreign relations: the exercise by a nation of taxing jurisdiction not appropriately founded on one or more of these factors would constitute a violation of customary international law

iv) Extraterritorial system: used by the US

(1) A domestic TP’s worldwide income, regardless of source, is subject to taxation by the country of residence

(2) In order to mitigate international double taxation, the country of residence grants the domestic TP a dollar-for-dollar credit for foreign income taxes paid by the domestic TP on foreign source income

v) Exemption / Territorial system: many types of a domestic TP’s income from foreign sources are exempt from tax in the country of residence

(1) Most countries with territorial systems do exercise residence-based taxing jurisdiction over certain types of foreign-source income, such as passive income or income earned in certain low-tax or no-tax foreign jurisdiction

b) International Enforcement Problems

i) The “revenue rule” : the US does not sue for taxes due in other countries though the TP can be found there, and the other country does the same

4) 1D – Some Basic Conceptual and Policy Issues

a) Introduction

b) Standards of International Tax Neutrality

i) Significant tax savings do influence where new investments are made

ii) Competing approaches to international tax neutrality

(1) Capital Export Neutrality

(a) Achieved when a US investor pays the same total amount of US and foreign tax on foreign-source income before tax as the total US tax it pays on US source income before tax

(b) US investor pays the same total US and foreign tax on all income, regardless of where the income is earned

(2) Capital Import Neutrality also called Competitive Neutrality

(a) All firms operating in the same industry in a particular country, whether owned by local or foreign interests, are taxed at the same level. The exemption or territorial approach to eliminating double taxation is compatible with capital import neutrality. Only the country in which the investment is made imposes tax: the country of the investor’s residence exempts foreign-source income

(3) National Neutrality

(a) Designed to ensure that total returns on capital are the same whether the investment is made abroad or in the US

(b) The same amount of current tax should be payable to the US treasury whether the earnings are from US investment or from foreign investment

(c) This model favors domestic investment over foreign investment because foreign income taxes should be deductible rather than creditable

(4) Capital-ownership Neutrality

(a) Would require the US to abandon the worldwide system and adopt am exemption system.

(b) Requires that the international tax rules of a country not distort ownership patterns of assets

c) International Double Taxation

i) When a single item of income is subject to income tax by more than one country

ii) The source country in which the income arises or is earned has initial and primary jurisdiction to tax the income

iii) Four principal mechanisms have been used to deal with the double taxation problem:

(1) Assume a given item of income may be taxed by Country A because it is received by a corporation organized under the laws of Country A, which taxes domestic corporations on their worldwide income. Country B may seek to tax the same item of income because it is earned or arises in (sourced) the territory of country B

(a) Unilateral devices for mitigating double taxation

(i) Country A can elect to use an “exemption” or “territorial” system of taxation and exempt income earned abroad from its tax. Under this approach there is no double tax because only Country B imposes tax on the income earned in Country B. Country A relinquishes taxing jurisdiction over the income earned outside its borders

(ii) Country A could follow the capital-export neutrality principle and grant a dollar-for-dollar credit against the tax it would otherwise impose for each dollar of Country B tax that has been paid on income earned there

(iii) Country A may treat the Country B tax as a deduction (as income taxes paid to states within the US are[local tax credit on FIT return]) in calculating the net income subject to Country A tax. This mitigates but does not eliminate double taxation

(b) Bilateral device for mitigating double taxation: Country A can reach an agreement with country B (treaty)

d) Deferral Principle

i) If a USC establishes a branch in a FC, the branch has no separate legal identity; no form of business org. law of that country is involved

(1) Branch is an extension of USC, income / loss is included in the tax of the USC

(2) If it has FSI, it is taxed in the US

(a) FSI can also be subject to the other country tax: US then gives foreign tax credit

ii) If a USC conducts business in another country through a subsidiary corporation, the income of that corporation is sourced outside of the US because of the separate legal personality of the subsidiary

(1) No US tax can be imposed on the foreign earnings unless and until they are distributed as a dividend or otherwise to the US parent corporation

iii) When congress determines that anti abuse measures are necessary in response to an instance of deferral, it typically chooses between three alternative ways:

(1) Immediate taxation of the US shareholders share of the FC’s foreign earnings on which US tax would otherwise be deferred

(2) Interest charge on the deferred tax

(3) Immediate taxation of the increase in the FMV of the US SH’s stock during the tax year

e) Tax Fairness: Horizontal and Vertical Equity

i) Horizontal equity: persons with equal economic incomes bear an equal tax burden

ii) Vertical equity: requires that persons with different economic incomes bear an “appropriately different” tax burden

f) Complexity

i) International tax rules are among the most complicated provisions of the IRC because;

(1) They are meant to serve economic and political policy objectives

(2) They represent compromises among the competing policy approaches

(3) The underlying transactions are often very complicated

(4) They improve the fairness and efficiency of the tax system

g) “Transfer Pricing” & Other Special Admin. Problems

i) US vests the IRS with the authority to adjust the price between related parties as necessary to reflect incomes clearly – § 482

ii) Adjust the price to one that might have been fixed for a comparable TXN between independent persons dealing at arm’s length

h) Cross-Borden Tax Arbitrage : exploiting inconsistencies to create double non-taxation

5) 1E – Some Basi

ividual was present in the US during the current year and preceding 2 calendar years (when multiplied by the applicable multiplier on the following table) equals or exceeds 183 days:

a. Current year 1 day = 1 day

b. First preceding year 1 day = 1/3 of a day (last year)

c. Second preceding year 1 day = 1/6 of a day (year before last)

(ii) Days excluded for the substantial presence test: (diplomats, full time employees of certain international organizations, their families, teachers, trainees and students, and professional athletes temporarily in the country for charitable sports events) will not be counted for purposes of the substantial presence test. The test also does not include a person who is physically unable to leave the US because of a medical condition that arose while the individual was present in the US – § 7701(b)(5)

(iii) “closer connection” exception: if the alien is actually present during fewer than 183 days during the current year and is able to show that she has a “tax home” in another country to which a “closer connection” exists, that alien will not be treated as a resident – § 7701(b)(3)(B)

1. A tax home is a place determined to be home for purposes of applying the “away from home” test for deductibility of traveling expenses in § 162(a)(2)

2. TP will have a closer connection if the individual “has maintained more significant contacts” with the foreign country than the US § 301.7701(b)-2(d)(1)

3. Factors:

a. TP’s permanent home,

b. TP’s family

c. TP’s personal belongings

d. Social, political, cultural, or religious organizations with which the TP has a current relationship

e. Place of TP’s routine personal banking activities

f. Place where TP’s business activities are conducted

g. Jurisdiction issuing the TP’s driver’s license

h. Jurisdiction in which TP votes

i. Place designated by the TP as his or her residence on official forms and documents

i. This exception does not apply to an alien who has a green card application pending

(c) First-Year Election

(i) An alien may make the election if the following 5 requirements are met:

1. The alien individual is not a resident of the US under either the green card test or the substantial presence test for the election year – § 7701(b)(4)(A)(i)

a. If the alien is a US resident under either of those tests, he has no election and must be treated as a US resident for federal tax purposes

2. The alien individual was not a resident of the US under the green card test, substantial presence test, or the first year election provision for the calendar year immediately before the election year – § 7701(b)(4)(A)(ii)

3. The alien individual is a resident of the US under the substantial presence test for the calendar year immediately after the election year – § 7701(b)(4)(A)(iii)

4. The alien individual is present in the US for a period of at least 31 consecutive days in the election year – § 7701(b)(4)(A)(iv)(I); and

5. The alien individual is present in the US for at least 75 percent of the number of days in the “testing period.” – § 7701(b)(4)(A)(iv)(II)

a. The testing period starts with the first day of the 31-day period referred to in (4) above and ends with the last day of the election year.

b. The statute treats an individual as present in the US for up to 5 days during the testing period even though the individual is actually absent from the US during those days