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Taxation in the global village

An Update on Foreign Taxes

By Jack R. Fay and Judson P. Stryker

Your company or your client is following the trend and starting to do business overseas. Do you know the taxation philosophy of the countries in which the company will be doing business? Their types of taxes? How taxes are administered? Tax incentives and forms of business for doing business overseas?

Globalization is a major issue faced by organizations throughout the world. As organizations become more internationalized, it is imperative their representatives be current on global issues, including tax consequences of multinational corporations. Many organizations and their representatives are entering the international field for the first time.

International Philosophies

Foreign-Source Income. What is it? Put simply, foreign-source income is income earned outside the U.S. The precise determination of whether income qualifies as domestic or foreign lies with the "source of income" rules. These rules are embodied in IRC Secs. 861 and 862 that provide tests for determining the source of income. If the income does not meet the tests for domestic income, it is foreign. Although the rules are too complex to discuss in depth, the main categories of U.S. domestic income are interest, dividends, personal-service income, rental and royalty income, disposition of U.S. property interest, sale or exchange of personal property, amounts received as underwriting income, and Social Security income.

If a U.S. corporation has foreign source income, what are the tax consequences? This depends in large part on the theory of taxation followed in the foreign country. There are two primary theories or philosophies of taxation used in the world today. These are the "territorial" and the "worldwide" theories.

Territorial. Under the territorial theory, countries tax only the income that originates within its borders. Businesses headquartered in these countries pay no tax on dividends or income from outside sources. Countries adhering to the "territorial view" include Argentina, Hong Kong, Panama, Switzerland, and Venezuela.

Worldwide. The majority of countries follow the "worldwide" principle. This view holds that a country has the right to tax all income earned by a corporation "domiciled, incorporated, or otherwise headquartered" within its borders, no matter the source. Such a system often leads to double taxation. The company may be required to pay taxes in the country of incorporation and in the country in which the income was received. Methods companies use to avoid this double taxation will be examined later.

Types of Taxes

Just as philosophies of taxation vary from country to country, so do the types of taxes and the systems used to administer them. The most common type of tax in the world is the corporate income tax, followed by the withholding tax and the value-added tax (VAT).

Corporate Income Tax. Rates are high in countries that depend exclusively on corporate income tax for revenue and low in countries anxious to encourage investment. Tax rates vary widely in developing countries. In addition, some countries have a local corporate income tax.

Withholding Tax. The second type of tax commonly found is the withholding tax. This is a tax levied on income (dividends, interest, royalties, etc.) returned to the parent company by the foreign subsidiary. The tax differs in amount from country to country and depends in large part on whether the U.S. has a tax treaty with the other country.

Value-Added Tax. The third major source of tax revenue is the value-added tax or VAT. The VAT is an indirect tax and the main source of revenue of the European Economic Community. Sometimes called the "tax on value added," VAT is applied to each stage of production, but only on the value added at that stage. The two methods for computing VAT are the additive method and the subtractive method. The following is an illustration of both methods, assuming VAT is 7%:

Additive Method

Value added in production:

Wages $400,000

Rent 20,000

Interest 40,000

Profit 20,000

Total $480,000

VAT payable:
$480,000 x.07 = $33,600

Subtractive Method

Sales Revenue $1,000,000

Less purchases of goods

and services on which VAT

has been paid 520,000

Total value added $ 480,000

VAT payable:
$480,000 x .07 = $ 33,600

European Community member countries are required to use the subtractive method. Firms subtract invoiced purchases from other firms from the selling price of their products and apply VAT to the difference. Although the method of applying VAT is uniform throughout Europe, the VAT rate is not.

Administration of International Taxes

Three international systems exist in the world to administer international taxes, the classical system, the partial-integration system, and the fully-integrated (assimilated) system.

Classical. The classical system, used by the U.S., is based on the entity theory of financial accounting and modern corporate law. It reflects the principle that a corporation is a separate legal entity and as such should be taxed as one. Under this system, profits may be taxed twice. Profits are taxed as increases to retained earnings of the corporation and taxed when distributed to shareholders in the form of dividends.

Partial Integration. The partial-integration system is further divided into two subsystems, the split-rate system and the tax-credit system. Under the split-rate system, the profits retained in the corporation are taxed at a higher rate than those distributed as dividends. Countries using this method include Germany and Japan. In Germany, for example, the maximum corporate income tax rate is 50%. This rate is reduced to 36% for distributions to stockholders. Under the tax-credit system, the retained and distributed profits are taxed at the same rate, but the shareholder receives a credit for taxes deemed paid by the corporation. Countries using this system include France, Italy, and the U.K.

Fully-Integrated. Under the fully-integrated system, no double taxation is allowed. Profits are taxed only to the corporation. At this time, however, China and Greece are the only major countries using this system.

Taxation of U.S. Multinational Corporations

Most industrialized nations, including the U.S., provide tax incentives, deferrals, or exemptions for corporations, primarily to support exports. U.S. corporations with transactions outside the country have used several different types of specialized corporate forms created by Congress to achieve these results. These corporate forms are the domestic international sales corporation (DISC), the foreign sales corporation (FSC), and the U.S. possessions corporation.

Domestic International Sales Corporation. The Revenue Act of 1971 introduced the DISC as a reaction to the declining level of U.S. exports. The DISC provisions provided a tax subsidy for U.S. corporations to conduct export sales through domestic subsidiaries. In other words, a DISC was a U.S. corporation created to export goods and services.

The Tax Act of 1984 significantly reduced the tax advantages of a DISC by 1) eliminating the tax deferral for DISC receipts in excess of $10 million, 2) levying an interest charge on the amount of each shareholder's portion of the DISC's post-1984 tax-deferred earnings, 3) eliminating the ability to make new DISC elections after December 31, 1984, and 4) revoking an existing DISC election whenever an FSC election is made by a corporation in the DISC's controlled group. Due to these restrictions, only a small number of DISCs still exist today.

Foreign Sales Corporation. The second corporate form available to U.S. multinationals is the FSC. The FSC was created by the Tax Reform Act of 1984 in an effort to curtail the use of the DISC. The FSC now replaces all but some small DISCs; there are currently about 4,500 FSCs used by U.S. corporations. Congress acted to replace the DISC with the FSC due to criticism by other countries involved in the General Agreement on Tariffs and Trade (GATT). GATT prohibits the exemption of exports from direct taxes. The DISC provisions did not actually exempt exports from direct tax. Some members of GATT, however, argued that because of the indefinite nature of the deferral, the tax benefits afforded a DISC were an "illegal export subsidy." The European Community requested retaliatory action against the U.S. by the GATT Council. To avoid these retaliatory measures, Congress acted to replace the DISC with the FSC as much as possible. The FSC conforms to the GATT rules. For a detailed explanation of the requirements of an FSC, see the article, "Shared Foreign Sales Corporations," by Joel D. Bonfiglio in the March 1995 issue of The CPA Journal.

U.S. Possessions Corporations. The provisions for the U.S. possessions attempt to encourage businesses to expand activities in Puerto Rico and the U.S. Virgin Islands. A domestic corporation qualifying as a possessions corporation is still taxed on its worldwide income. IRC Sec. 936, however, permits these corporations to claim a special tax credit that effectively exempts certain non-U.S. income.

IRC Sec. 936 has been amended by IRC Sec. 13227 of RRA '93. For taxable years beginning after December 31, 1993, the possessions tax credit may be reduced. A corporation that uses the credit may select an economic activity limitation or a percentage limitation. The election must be made for the first taxable year beginning after 1993 and will be binding on all future years.

The economic activity limits the credit to the sum of 60% of the wages and fringe benefits paid within the U.S. possession and the following percentages on the depreciation allowance on property used in the U.S. possession in the conduct of an active trade or business:

* 15% on short-lived property (3 or 5 years),

* 40% on medium-lived property (7 or 10 years), and

* 60% on long-lived property.

Possessions companies should probably consider opportunities to utilize additional possessions credits by increasing their economic-activity limitation.

For companies electing the percentage limitation, the credit for active possessions business income is limited for taxable years beginning in 1994 to 60% of the otherwise allowable credit. This limit decreases (five percentage points each year) to 40% for taxable years beginning in 1998 and thereafter.

Many possessions corporations that have been exempt from tax due to the IRC Sec. 936 credit have or will become subject to U.S. corporate income tax as a result of these new limitations.

Other Incentives and Relief

In addition to specialized corporate forms, the U.S. government uses other means to encourage exports by multinationals and help alleviate the burden of double taxation. Among these are tax treaties, tax havens, and tax credits (or deductions).

Tax Treaties. Tax treaties minimize the cost for U.S. multinationals of doing business in other countries. The power to make a treaty is given to the President by the U.S. Constitution. A tax treaty, once ratified by the Senate, has the same legal status as any other law adopted by the government. A tax treaty's main goal is minimization of double taxation. The U.S. (as of December 31, 1994) is currently a party to bilateral tax treaties with the countries listed in the Exhibit.

Income tax treaties have two major objectives: 1) to reduce or eliminate the burden of double taxation and 2) to establish cooperation between the taxing authorities of the two involved nations. An income tax treaty involving the U.S. cannot be used by a U.S. citizen or domestic corporation to reduce a U.S. income tax liability. U.S. citizens and domestic corporations are still taxed on their worldwide income at the regular U.S. tax rates. The tax treaty, however, can reduce the income taxes paid to the foreign country and may eliminate or reduce problems U.S. taxpayers may have with foreign tax credits. Tax treaties also provide exchanges of information between the nations' taxing authorities to prevent tax evasion and establish mechanisms by which taxpayers of one country may settle tax disputes with the taxing authorities of the second country. Many common elements are found in most tax treaties. Among them are‹

* a definition of affected taxpayers‹treaties are applicable to residents and they usually include a fiscal domicile clause that prescribes criteria to be applied to determine corporate residency. Among the criteria are state of incorporation, domicile, residency, and place of management. If a corporation is found to have dual residency, it usually loses treaty benefits.

* the taxes affected by the treaty--generally, the national income tax is the only one affected.

* a nondiscrimination clause--this assures the foreign corporation is not taxed more heavily than the domestic corporation.

* a preservation clause--this preserves exclusions, credits, and deductions that might otherwise be limited by a treaty. This assures that a treaty does not increase tax liability.

* a savings clause--this means a country's citizens and residents are taxed as if the treaty did not exist. In other words, the U.S. tax liability of a U.S. corporation is not affected by its place of residency or source of taxable income.

The actual reduction of double taxation is achieved by exempting income from taxation by the host country, reducing the tax rate, or allowing a credit for foreign taxes paid or accrued.

When a U.S. corporation earns income in a country that is a party to a treaty with the U.S., the profits are not taxed by the host country unless the business is conducted through a permanent establishment. If the business is conducted through a permanent establishment, profits are taxed at the host country's normal corporate tax rate.

The definition of permanent establishment varies from country to country. The Model Income Tax Treaty adopted by the U.S. Treasury defines permanent establishment as a "fixed place of business through which the business of an enterprise is wholly or partly carried on." The term includes a branch, an office, a factory and a workshop.

Examples of what is not considered a permanent establishment include‹

* using a facility for storage, display, or delivery of goods and the maintenance of these goods for processing;

* maintaining a fixed place of business for purchasing goods or collecting information; and

* using agents of the corporation, except when they have authority and exercise authority to contract in the name of the corporation.

As stated previously, the profits of a permanent establishment are taxed at the normal corporate rate of the host country. These profits, however, do not usually include dividends, interest, rent, royalties, or gains from the sale of corporate assets. These are considered passive income and taxed at special rates.

Tax Havens. A tax haven is defined as "a place where foreigners may receive income or own assets without paying high rates of tax upon them." Some common characteristics of tax havens include low tax or no tax on certain classes of income; high level of secrecy in the banking industry; sophisticated banking and financial services; availability of modern communication facilities; and lack of currency controls on foreign deposits of foreign currency.

The main categories of tax havens are‹

* countries with no income tax, such as Bahamas, Bermuda, Cayman Islands, Haiti, and Turks and Caicos Islands;

* countries with low tax rates, such as British Virgin Islands, Hong Kong, Macau, and Switzerland;

* countries that tax domestic source income but exempt foreign source income, such as Hong Kong and Panama; and

* countries that allow special tax privileges.

To be effective, a tax-haven country should have political and economic stability, freely convertible currency, sophisticated banking and financial services, and accessibility to a good, worldwide communications system. To take advantage of tax havens, corporations usually establish a holding company in the tax haven country. Holding companies are basically inactive or "mailbox" corporations established for the purpose of owning a controlling interest in an active corporation. The goal is to shift income from the high tax country to the tax haven country by using the holding company as an intermediary. Income is shifted to these companies by assigning export, patent, and licensing rights to them. A U.S. manufacturer could sell goods directly to a dealer in the U.K. and concentrate profit in the U.S.; or it could sell goods to a tax haven subsidiary at cost, and then sell the goods to the dealer, concentrating profit in the tax haven country. The Revenue Act of 1962 curtailed the use of tax havens by U.S. companies, but they continue to be used extensively by foreign international corporations.

Foreign Tax Credit or Deduction. The U.S. government permits either a deduction or a credit for taxes deemed paid to a foreign country. When taken as a deduction, the taxes are subtracted from income as an expense of conducting business. The primary advantage of taking the tax as a deduction is that the deduction is unlimited while the tax credit is limited.

Even though the deduction has a major advantage, most firms find it more beneficial to take the tax credit. The credit allows reduction of tax liability on a dollar-for-dollar basis. A U.S. corporation may directly reduce its tax liability by the amount of income tax paid to a foreign government. The tax, however, must be an income tax as defined by the U.S. government to be eligible for the credit. Indirect taxes, such as VAT, would qualify for the deduction but not the credit.

The IRS uses three tests to determine if a tax is an income tax: the realization test, the gross-receipts test, and the net-income test.

The realization test is met if the tax is imposed at the time income is earned or just after that time (as defined by the IRC). The gross receipts test is met if the tax is based on the gross receipts of the firm. The net income test is met if the tax is imposed on gross receipts reduced by expenses incurred to produce the income.

The credit applies to all income recognized by the parent, with the exception of that income arising from boycott-related activities. The credit is further limited by IRC Sec. 904.

The tax credit itself must be computed first. An illustration is as follows where EBFT is earnings before foreign tax and EAFT is earnings after foreign tax:

EBFT $ 600,000

Foreign income tax paid 180,000

EAFT $ 420,000

Dividends paid 168,000

Withholding tax ­ 15% 25,200

Net dividend received $ 142,800

Computation of tax credit:

Direct credit for

withholding tax $25,200

Deemed direct credit:

Dividends/EAFT x foreign

tax; $168,000/$420,000

x $180,000= 72,000

Total credit $97,200

Next, assume the U.S. corporation's worldwide income is $1,000,000 and its U.S. tax liability is $340,000. The amount of income from its foreign operations included in the total figure is:

Dividends $168,000

Deemed credit 72,000

Included in income $240,000

The addition of the deemed credit to the dividend is known as "grossing up the dividend." The IRC Sec. 904 limitation is then ascertained by computing the percentage relationship between foreign source income and total worldwide income and applying that percentage to the U.S. tax liability. In the above example, this would be $240,000/$1,000,000 x $340,000 or $81,600.

The difference between the $97,200 credit computed earlier and the $81,600 allowable amount may be carried back two years and forward five years. As some countries have higher corporate tax rates than the U.S., many U.S. multinational firms eventually have large excess credits that may never be applied. *

Jack R. Fay, PhD, CPA, is an associate professor and Judson P. Stryker, PhD, CPA, is a professor, at Stetson University.

Argentina

Greece

Pakistan

Aruba

Hungary

Philippines

Australia

Austria

Iceland

India

Poland

Portugal (updated on

9/15/94)

Romania

Bangladesh

Indonesia

Russian Federation

Barbados

Ireland

Slovak Republic

Belgium

Israel (updated on

12/30/94)

Spain

Bermuda

Italy

Sri Lanka

Canada (updated on

8/31/94)

Jamaica

Japan

Sweden (updated on

9/1/94)

China

Korea

Switzerland

Commonwealth of
Independent States

Cyprus

Czech Republic

Denmark

Egypt

Finland

France (updated on

8/31/94)

Germany

Luxembourg

Malta

Mexico

Morocco

Netherlands Netherland Antilles

New Zealand Nigeria

Norway

Republic of South Africa

Thailand

Trinidad & Tobago

Tunisia

United Arab Republics

United Kingdom

EXHIBIT

U.S. Tax Treaty Countries

OCTOBER 1995 / THE CPA JOURNAL



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