International Tax Planning for U.S. Corporations

International Tax Planning for U.S. Corporations

Taxing earnings of foreign corporations

The U.S. tax system generally recognizes the separate identity of corporations, even when they’re owned and controlled by a single person or a small group. The earnings of domestic corporations are taxed twice: one tax is imposed on the income of an entity, and another is imposed on dividend distributions to shareholders.

In international transactions, however, the separate identity of corporations may prevent the U.S. from taxing the earnings of foreign corporations owned by U.S. persons. Because a foreign corporation is a separate foreign person – and hence a separate foreign taxpayer – it’s not immediately subject to U.S. taxation on its income derived outside the U.S.

Dividend received deductions (DRD) from foreign corporations

A U.S. corporation that receives a dividend from a specified 10%-owned foreign corporation with respect to which the domestic corporation is a U.S. shareholder may be entitled to a dividends received deduction (DRD) under §245A.

A specified 10%-owned foreign corporation is a foreign corporation that has any domestic corporation as a U.S. shareholder. And a U.S. shareholder is any U.S. person who owns 10% or more (by vote or value) of stock in the foreign corporation.

The §245A DRD amount is equal to 100% of the “foreign-source portion” of the dividend, but certain holding period requirements apply. Any taxpayer who receives a §245A DRD may not claim a foreign tax credit or take a deduction for any taxes paid or accrued with respect to the dividend for which the §245A DRD is allowed. If you haven’t already, consider reviewing your business structure to determine if your company can benefit from this deduction.

Controlled foreign corporations and subpart F income

U.S. shareholders are generally required to include in income their pro rata share of subpart F income, including the amount of subpart F income of a CFC whose stock they owned on the last day in that year.

However, the final §956 regulations issued in 2019 allow certain corporate U.S. shareholders of CFCs to reduce the amount of income inclusion determined under §956 to the extent the shareholders are eligible for the §245A DRD. It’s important to review the taxpayer’s ownership structure to determine whether these changes apply to them.

Sale of interest in partnerships engaged in U.S. trade or business

A nonresident alien individual or foreign corporation that owns, directly or indirectly, an interest in a partnership that’s engaged in a U.S. trade or business may be treated as deriving gain or loss that’s effectively connected with such trade or business upon the sale or exchange of all or a portion of the partnership interest. A nonresident alien individual or foreign corporation that’s treated as deriving effectively connected gain or loss may be subject to a U.S. withholding tax.

Generally, if withholding is required, the transferee purchasing the partnership interest must withhold 10% of the amount realized on the sale or exchange. Thus, a taxpayer purchasing any such interest from a foreign person may be required to withhold 10% of the amount realized. If the taxpayer fails to withhold the correct amount, the partnership in which the taxpayer owns an interest is obligated to deduct and withhold from distributions to the taxpayer in the amount equal to 10% of the gain realized by the transferor plus interest, if any. However, there is no liability for failure to withhold, or any interest, penalties, or additions to tax, if the person required to withhold establishes that no gain on the transfer is treated as effectively connected with the conduct of a U.S. trade or business.

Transfer pricing, income shifting, and tax havens

The U.S. system of taxing foreign income may seem straightforward at first glance but can become overwhelmingly complex upon closer examination. This complexity is the product of an effort to formalize distinctions in U.S. tax law between legitimate business operations outside the U.S. and maneuvers considered to be tax haven operations.

A tax haven isn’t always immediately obvious. What makes a particular environment a tax haven isn’t invariably a low tax rate, but relations with other tax regimes that permit the ultimate deflection of income to a low-tax environment with which the income may have little economic connection. The U.S. tax system tends to consider international tax shelters to be transactional arrangements structured so that the underlying business activity and taxation occur in different places.

It should be noted that a low-taxed foreign business undertaking is not in itself a tax haven. For example, a resort hotel and casino owned and operated by a Cayman Islands subsidiary of a U.S. corporation wouldn’t be considered a tax shelter from the perspective of the U.S. tax system, even though taxation in the Caymans is beneficial. If, however, ownership of a Miami hotel were structured so that its income was taxed in the Cayman Islands rather than the U.S., that would be a tax haven operation. International tax shelters have been severely constrained by statutes and treaties in recent decades.

An essential pattern in many international tax-sheltering operations is “income shifting,” which consists of arranging for income to be taxed in a country other than the one where it arose as an economic matter. The latter is typically a high-tax environment, while the former is not. A recurring ingredient in income shifting is artificial pricing in transactions between related persons, a problem known generally as “transfer pricing.” There is a battery of provisions in the U.S. tax system aimed at artificial transfer pricing in international transactions.

The mechanics of the transfer pricing rules continue to apply as in prior years. However, the IRS’s authority to require the valuation of transfers of intangibles on an aggregate basis or based on the realistic alternatives to such transfers has been confirmed by statute.

In addition, the definition of “intangible property” has been expanded to include goodwill, going concern value, and workforce in place. Therefore, if a taxpayer engaged in transactions that involved the transfer of intangibles during the year, the taxpayer must keep in mind that the IRS may arrive at a different value.

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