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NYU Int'l Tax Outline

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					International Tax Outline INTRODUCTION AND CONCEPTUAL OVERVIEW  Designing a System for Taxing International Transactions o Two basic categories:  (1) Inbound – taxation of income earned in US by foreign persons  (2) Outbound – taxation of income earned outside US by US citizens o Possible Lines of Analysis:  The two plausible are based on (1) domicile or permanent residence and (2) location of wealth (situs)  Ideal solution: Taxed only once and the liability should be divided among the tax districts according to TP’s relative interest in each o Reasons for having an Int’l Tax Regime:  Overlapping Entitlements  A US person earning income is Germany is outbound transaction for US, but inbound transaction for Germany  Can lead to double taxation if it is taxed differently  Efficiency Losses  Assume F investment yields 8% and US investment yields 6% (both pre-tax) of $1000 - both US and F have 25% tax rate o US Co invests in F  $80 taxed by F both US at 25%  $40 after tax return o US Co invest in US  $60 taxed only by US at 25%  $45 after tax return o Result: steers capital toward 6% yield rather than 8% yield  Without a system to address this  deterrent on global investment  To go from two tax to one tax, one J will have to give up its right to tax o Criteria for Determining Status as “Outsider” or “Insider”  Note: the criteria should be different for different types of TPs  Individuals: what should make them an “insider”?  Citizenship (the rule under US system) o Rationale?  national protection, right to vote o Most Js do not use this regime  Residence o Greater consumption of benefits at place of residence than where passport is held, but right to vote (closely tied to requirement to pay taxes) is probably why we don’t base it on residence  Corporations: what should make them an “insider”?  Place of Incorporation (the rule under US system)  Other Possibilities: Place of Management; Principal Place of Business; Status of Individual Owners (SHs) (administratively impossible) o Respecting Separateness of Corporate Entities (under common control) 1

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 Ex: US Parent and F sub  Respect the Line: possibility of shifting assets / income outside US tax base  Don’t Respect the Line: no different from a branch o Taxing returns from labor (wage) income vs. capital (dividend):  Much easier to shift capital to different J than labor o Taxing Active (trade or business) Income vs. Passive Income  Outbound Motivations: US Corp has activity in F country  Active: Jobs - US prefers that US corp keeps its activity here  Passive: Mobility – erosion of tax base if mobility is easy  Inbound Motivations: F corp has activity in US  Active: Competition: must tax same as a domestic corp so that domestic coprs can equally compete  Passive: Capital flows in – tax system should attract this o Administrative Issues:  Inbound: Corp might not have assets in US to levy to collect tax  Outbound: lack of information Double Tax Relief and International Neutrality Theories o Three ways to offer relief from double tax: credit, exemption, or deduction o Mechanics:  Ex: US corp earns F income of $500 (F tax of 20% and US tax of 40%)  Credit Method  TP pays F tax of $100 and US tax of $200  US grants $100 credit against the $200 US tax  total liability of $200  Exemption  Not a worldwide taxation system  US exempts the F income from tax  Total tax liability = $100  Deduction  Income of $500 and US grants deduction for $100 F tax paid  US tax = $400 x .40 = 160 US tax  Total tax liability = $260 o Deduction = least generous; Exemption = most generous o Neutrality Theories:  Neutral: idea is that that tax system should not distort b/w equal investments on a pre-tax basis  CEN: Neutrality as to where investment is made  CIN: Neutrality as to who makes the investment (US vs. F person)  Capital Export Neutrality (CEN)  Goal: Decision to invest will be wherever pre-tax returns are greatest; Taxation of a US investment is the same as taxation of a F investment after being subject to both US and F tax o To get total tax to 35% o Gives double tax relief in a worldwide system  If F rate is lower  credit

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 If F rate is the same  credit or exemption  If F rate is higher  refundable credit Capital Import Neutrality (CIN)  Only country where investment is made imposes tax; country of residence exempts the F source income o Gives double tax relief in territorial system  Goal: There is a F investment. Goal is to have US investor face the F rate (same as other people considering investment – “competitive neutraility”)  If F rate is lower  exemption  If F rate is same  exemption or credit  If F rate is higher  exemption or credit Choosing CEN vs. CIN  Note: You cannot have both  To choose, see what happens when you violate one under  Violation of CEN  Exemption Method (trying to decide between where and use the exemption method) o US Mfger Co considering $1000 investment in either US Target (8% yield) or Irish Target (6% yield)  US Corp tax = 40%  Irish Corp tax = 10% o Invest in US Target:  Return = $80  $32 tax  $48 for SH o Invest in Irish Target  Return = $60  $6 tax  $54 for SH o Capital steered to lower yield investment  Violation of CIN  Credit Method (trying to decide b/w who and use the credit method) o There is a $1000 investment opportunity in Irish Target Co that will yield 6%  US corp tax = 40%  Irish corp tax = 10%  Question is whether a US Mfger Co or a Irish Mfger Co should make the investment o US Mfger makes the investment:  Return = $60  $24 US tax, $6 Irish tax  Credit of $6  $18 US tax  total $24 tax  $36 for SH o Irish Mfger Co makes investment  Return = $60  $6 tax  $54 for SH o Favors Irish Mfger Co  Argument of CEN is that TPs are more responsive to where question than to the who question National Neutrality (NN)  Goal is to ensure total US tax revenue is the same, whether investment is made in US or abroad 3

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o Result is a deduction o But it is not neutral Question or where: should US Co invest in Irish Target or US Target o Must give some relief for F tax paid b/c not in our interest to encourage companies to move abroad NN is not a viable option because of what other countries will do in response

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Deferral Principle o Issue is the different tax treatment when US parent operates through F branch vs. F sub o Legal Distinction:  Sub is corp entity: enter into contracts; hold title to property, subject to being sued (all things that don’t apply to branch)  With a sub, there is a new TP  an “outsider” o Taxation:  Branch: profits to the branch get taxed on Parent’s return  Sub: money into sub is not taxed to parent while still held by sub (share value of parent may rise, but that is not taxed)  Parent only taxed if distribution or if Parent sells the shares o Efficiency Models  CEN calls for elimination of deferral  CIN suggests that only F country taxes the profits  If deferred indefinitely = exemption Equity o Horizontal Equity: requires that persons with equal economic incomes bear and equal tax burden  Consistent with CEN; Inconsistent with CIN o Vertical Equity: focuses on distribution of tax burden among persons with different levels of income and requires that they bear an appropriately different tax burden  Consistent with CEN o Note: if you satisfy VE, the HE falls into place Who is Subject to Worldwide Taxation? o US Persons: subject to WW tax, but Code does not say directly  Statutory Chain: Sec 1(a) – 1(e) give rates for taxable income  Sec 63 defines taxable income  Sec 61 defines gross income  Cook v. Tait: Supreme Court case that held Congress has the power to tax US citizens on worldwide income o Non-resident Aliens:  7701(b)(1)(B): A nonresident alien is an individual that is neither a citizen of the US nor a resident of the US  Sec 2(d): subject to taxes imposed by Sec 1 as determined under 871 or 877 o Resident Aliens  77001(b)91)(A) an individual shall be treated as a resident of the US if an only if he meets the requirements of clause (i), (ii), or (iii)  (i) Green card test: lawfully admitted for permanent residence  (ii) Substantial Presence Test

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 (iii) First Year Election Substantial Presence Test – 7701(b)(3):  Contains a general mechanical test and a subjective exception  (A) Test is met if individual was present within the US during the tax year at least 31 days and was present within US for 183 days during the tax year and two preceding years as determined under the following formula: o Current year: 1 day = 1 day o First preceding year: 1 day = 1/3 day o Second preceding year: 1 day = 1/6 day  Safe harbor: 121 days in US (guaranteed never to meet test)  Closer Connection Exception o (B) If individual is present fewer than 187 days during current year (but still meets mechanical test) and is able to show he has a “tax home” in another country to which a “closer connection” exists, then individual will not be treated as resident o Closer connection = more significant contacts with F country (facts and circumstances)  Relevant factors on p. 39 o Tax home = principal placer of business (threshold) o In determining a closer connection the relative facts are not just “tallied up”  must do a subjective comparison  Owning property in both countries does not just cancel each other out  To avoid substantial presence test: o A TP has to either cut the number of days spent in US or increase the subjective factors that link him to F country First Year Election – 7701(b)(4)  If an alien meets the substantial presence test in a given year, he can elect to be treated as a resident alien for the preceding year if: o TP was in the US for at least 31 consecutive days o TP was in US for 75% of the testing period  Testing period: starts on first day of 31 day period and ends on last day of taxable year  An individual might make a first year election (even though it brings more income into base) because taxation for a resident alien = net taxation vs. NRA = gross taxation Treatment of Property transferred into US  Assume F citizen is considering immigrating to US and has both appreciated property and depreciated property that she wants to sell  Threshold: what are the relative rates? o If they are different, TP will want to sell the loss property in the higher rate J o But assume rates are identical:  TP’s basis: 5

o Worst case scenario: F country imposes exit tax and new country requires individual to keep historic basis (double tax on appreciation) o No clear answer on basis – most countries have rule that TP takes a FMV basis o Standard rule: take F basis as reflected on F financials unless the country departs substantially form US practices o Sec 877 – Special Rules of Former U.S Citizens and Long-Term Permanent Residents  Rationale: To tax individuals who try to shed US connection to get into a lower tax J  877(a) = trigger provision  877(b) = substance – alternative tax  877(a) – Trigger  Under recent amendments, the triggers to get person under 877 are objective triggers based on wealth: o (1) average annual net income tax liability over preceding 5 years before lost of citizenship is greater than $124,000 or o (2) net worth of individual is $2M or more  877(c) – Exceptions  Note: the exceptions are not something that TP can plan into  In general only two basic exceptions o (c)(2): individual who:  (A) became at birth a US citizen and citizen of another country (dual citizens)  (B): has had no substantial contacts with US (never a US resident, never held US passport, never in US for more than 30 days during any of 10 years prior to loss)  877(c)(3) exception for certain minors if four conditions are met  877(b) – Substance  Individual’s gross income will be determined under 872(a) (provision for FP) as modified by 877(d)  877(d) modifies certain source rules – for personal property and stock of a US corp o Normally a F person would not owe tax on such, but 877(d) flips sourcing rules to make such gains US source  877 also puts TP into Sec 1 tax rates  progressive rates o US Corporations  7701(a)(4): a domestic corp is one which is incorporated in the US  US corps are subject to rates in 11(a)  Sec 11(d): a foreign corp will be taxed according to sec 882 o Partnerships  More difficult than corps to determine which J p-ship is in  Assume both US and F SHs hold and entity (either SHs or partners) Difference in status of p-ship vs. corp is huge  If it’s a US corp, once income flows through it, the US can capture it 6

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 But a p-ship is not a taxable entity Same when US SHs hold either a F corp vs. F p-ship  The F corp would provide deferral, the p-ship would not  Note: deferral good for gain, but not for losses (new start-up)

Tax Treaties o Treaties are bilateral instruments o The starting point (first offer) is the US model treaty o Function: eliminate double taxation and prevent fiscal evasion o Two jurisdictions: one source of income and one residence of TP (both could have authority to tax)  Treaty will limit the taxation of one of the Js o Beneficiaries of Treaty Provisions  The taxation turns on who is a “resident” under Article 4:  Rule: if country taxes you as a resident, then you are a resident for purposes of treaty  There are tiebreakers if TP is considered a resident of both  US tax treaty does not reduce US taxes on citizen or domestic corps- it reduces taxes imposed by foreign country o Allocation of Taxing J over Income Items  Normally, the country of source relinquishes to (or shares with) the country of residence taxing J  Business Income  “Business profits” for a business are typically exempt from tax in the source country, unless the profits are attributable to a PE in the source country  Non-business Income  Typically reduces or eliminates the WH tax on at least some items of investment type income such as interest, dividends, rents, an royalties o Treaty Shopping  There could be incentive to form a corp in a country that is a US treaty partner to reduce US taxes  There are multiple ways treaties deal with this: “anti-treaty shopping rules”; “anti-conduit regs”; “limitation on benefits” o “Later in Time” Rule: US treaties and federal laws have equal status as supreme law of the land – the later in time provision controls

SOURCE OF INCOME: WHY SOURCE MATTERS AND SOURCE RULES  Importance of Source Rules o Source matters for both outbound and inbound consequences:  Outbound: Determination of FTC for a US person  The FTC is limited by the FTC limitation in order to eliminate a “defector refundable credit”  We need source rules to determine the limitation since it is based on F source income

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o TP always tries to increase F Source income to increase their limitation  Inbound: Determination of taxable income for a F person  Two tracks: active and passive  TP will be subject to a subset of active US source income  For passive income, if it is US source, then it is taxable o 861: US Source Income o 862: F source income Interest o General rule: sourced to the residence of the payor – 861(a)(1)  It seems arbitrary, but other options are not administratively possible o Exceptions:  Foreign Business Rule – 861(c)  When a US corp is paying interest, if more than 80% of the corp’s income is F source income over a 3 year period, then 100% of the interest paid is F source o Note the cliff effect b/w 79% and 80% F source income  Exception: if paid to a related party, then there will be proportionate source based on the payor’s income o Does that mean still have to meet 80% threshold?  Foreign Bank Branches – 861(a)(1)(B)  Interest paid by F branch of a US bank will be F sourced (even though payor is US corp)  Rule of competitiveness society because F depositors would never deposit in the F branch  Branch Profits Tax  884(f)(1): interest paid by the US trade or business of a F corp will be treated as if paid by a domestic corp Dividends o General rule: Dividends paid from a US corp = US source – 861(a)(2) o Dividends paid by Foreign Corp: generally will be F source, BUT  Trigger: if greater than or equal to 25% of F corp’s GI is income that is effectively connected to a US trade or business, then a portion of dividend will be US source  Proportion of Dividend that is US source = proportion of income that is ECI  Note: this rule almost never applies b/c it is trumped by Sec 884 Branch Profits Tax Rents and Royalties – 861(a)(4), 862(a)(4) o General rule: “place of use” rule  Rents from tangible property (e.g. building) are sourced where physically located  Royalties for intangible property is sourced to where the rights are used – generally the country in which the IP derives its protection

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o RR 68-443: X (resident F corp) licenses a trademark (TM) to Y (US corp) to allow Y to place the TM on Y’s products. Y’s products are manufactured in US and then sold to F buyers inside the US for resale and consumption in F countries.  Z, unrelated party holds the US TM  Issue: does the initial sale in US mean that Y has “used” the TM in US  No, the initial sale was just a means of placing the products in commerce  Held: The royalties paid by Y to X are paid for the use of the TM in the F countries  F source o SDI Netherlands B.V. v. CIR: Three related corps: SDI Bermuda holds SDI Netherlands with holds SDI USA. Bermuda has all rights to the property. Bermuda licenses worldwide rights to Netherlands. Then Netherlands sub-licenses it to toher subs, including USA. Therefore, royalty payment flows from USA to Netherlands to Bermuda.  Issue: When Netherlands pays royalty to Bermuda, a portion is from the USA royalty received.  CIR’s view is that you trace the royalty and it retains its US source  CIR relies on 80-362, a similar ruling that said that the royalties paid by (Netherlands) to (Bermuda) were subject to WH tax  Court says there is no support for CIR’s position – instead it looks at Aiken and N. Indiana – both involved a back to back interest payments involving an intermediary  Aiken: Parties left nothing in intermediary – intermediary disregarded – payment treated as going from US corp straight to Parent = US source  N. Indiana: Parties left a spread in the intermediary – not disregarded b/c engaged in substantive business activity  Court rules that this case is similar to N. Indiana:  The two licensing agreements had separate and distinct terms  Netherlands engaged in licensing activities from which it realized substantial earnings  The arrangements should get separate status and treated as separate payments  Problem with CIR’s view (and 80-362) is that it results in cascading royalties: multiple WH taxes on same royalty payment as transferred up chain of licensors  Here, only one WH tax being sought, but only because a treaty exempts the tax on the payment from USA to Netherlands  Kane says its odd that court said no authority for CIR’s position, when the actual statute seems to lend support  But it could be that treaty obligations are driving the decision  It would be against policy to exempt the tax when paid from US to Netherlands, but then to “sneak in back door” and tax it when it goes form Netherlands to Bermuda Compensation for Personal Services – 861(a)(3), 862(a)(3) o General rule: source of income is place where the services are performed 9

Threshold: whether the income is in fact compensation of performance of services o RR 60-55: Commissions paid by a US corp to a F corp (TP) and issue is whether they are US source.  The TP purchases property from US corp and sells it to F persons. When a F person buys the property directly from the US corp, the US corp pays TP a commission b/c the sale would not have occurred without the promotional work of TP  Repeatedly held that place were the services are performed and not where compensation is paid controls  Here, commissions were paid for services performed in F countries  F source o De Minimis Exception: Compensation earned by a NRA will not be US source if (1) TP is present for 90 days or less during tax year, (2) compensation does not exceed $3000, and (3) work is performed on behalf of F person or entity not engaged in US TB  Exception=/= very helpful o Allocation of Compensation Income  Services performed partly within and partly without US, compensation will be apportioned b/w US and F source  Reg 1.861-4(b)(1)i): method of apportionment shall be determined on basis that most correctly reflects proper source under F/C (usually reflects number of days worked in US)  Stemkowski v. CIR: TP was Canadian resident (NRA) and played for Rangers. Salary was for performance of services. Must determine what percentage of time that is covered by the contract did he spend in US  real issue is what period of time does the contract cover.  US source income = Salary x (number of days in US / total days covered by K)  TP wants fraction small, i.e. larger denominator  Tax Court: only regular season covered  reversed  Court holds that training camp, the regular season, and playoffs are included in the denominator (not off-season)  Note: No 7701(b) at this time – otherwise he would be a NRA  The Reg has a default rule of time basis, unless TP can prove another allocation is more appropriate o Ex: job requires 2 months in Iraq – can allocate more than 2 months b/c some of salary is for danger  Condition of Employment Doctrine: Court emphasizes that offseason was not part of employment  Corps vs. Individuals: o An individual has to use the time basis rule o A corp may use the time basis rule or allocate based on F/C o Distinction b/c most individuals have constant value for their services, but corps may enter service contrcts that embed many individuals

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o Compensation vs. Royalty Income  Boulez v. CIR: TP lives in Germany and enters into k with CBS recordes. K provides for him to come to US and make records. The payment is contingent on sales. TP wants it characterized as royalties (b/c treaty existed that exempted taxes on royalties). IRS argues that K is for services being performed in US and therefore US source.  The payment was labeled as “royalties” in the K, but court says it doesn’t mater what you call it o TP must have had “property interest” o Royalties are an income stream generated by some sort of property right  Note: on these facts, both a royalty (place of use) and comp for services (place of performance) would both be US source – but issue is what the treaty will exempt  Note: based on this ruling, it is easier for TP to manipulate the source – he could just move somewhere else to perform the services  What is “Property”?  When you compare a staff writer on a newspaper to an author it’s easy to see who has the property rights  Two factors: Risk and Control – fundamental features of a property right  It seems as Boulez is sort of in the middle – he has neither infinite risk and control or none at all o He has risk because he is paid based on sales o Both Boulez and CBS had control o Payment to Induce Execution of Employment Contract  Linesman: NRA hockey player received signing bonus for signing with US hockey team. CIR argues that it is prepaid compensation for future services so source where to be performed. TP argues that it is partially a payment to break contract with his former club.  Court said to allocate b/w US and F sources based on number of games to be played in US  BLR for Signing Bonuses: Sourced to where services are to be performed o Covenants Not to Compete  Korfund: Issue is how to source money paid by a F corp to a US person in exchange for CNC (in US). TP argues to source to payor and IRS argues that US source b/c place of performance is US. Court holds that it is US source b/c the rights given up were interest in property in the US.  RR 74-108: A sign on fee was paid to a NRA individual by a domestic corp (soccer club). The agreement did not require individual to play, only precluded him from recruitment of other clubs. Ruling follows Korfund and source it to where the individual forfeited his right to act (apportioned b/w US and F source)  Confusion re: CNC and Signing Bonuses  Confusing b/c attempt to source where you don’t do something

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o TPs try to argue that the restraint to perform in US happens in F country (but court rightly disagrees) Kane’s Justification for the Rule: o Must think about it in the aggregate – both from payor and payee perspective o The person paying the CNC is entitled to a deduction  decreases US tax base of payor  must pick it back up by sourcing to US on payee side

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Property o Default Rule: Sourced to the residence of the seller – 865(a) o Sale of Real Property: sourced to where the property is located o There are four major exceptions to the general rule of source to residence of seller: inventory, depreciable property, intangible property, gain from stock in F affiliated corp o Inventory Property  Exception for inventory property under 865(b)  Two categories of inventory property: purchase and sale of inventory (861(a)(6), 862(a)(6))and production (manufacturing) and sale of inventory (863(b))  Purchase and Sale  Title Passage Rule o 861(a)(6): Inventory bought in F country and sold in US (title passes in US) = US source o 862(a)(6): Inventory bought in US and sold in F country (title passes in F country) = F source o No code provision: Inventory bought in US and sold in US = US source  Note: The title passage rule allows the TP to plan into the result  AP Green Export Co. v. US: US parent sells brick to US sub and US sub sells brick to F buyer – title passes outside US. TP argues that it’s prudent to hold title until goods are out of US b/c that way TP still has title if something bad were to happen (trade embargo, pirates, etc - but this argument can be for any exporter). o IRS argues that there is no substance in the US sub o Court holds that the form will be respected as long as retention of title was not a sham, but had commercial purpose.  The title passage rule is very formalistic  Production and Sale of Property  863(b): Mixed-source Rule – income party US source and party F source  Assume a US Mfg Co sells to a F purchaser (i.e. there is no export agent in the middile) o Some of the income is attributable to the manufacturing and some on the sale  Two Methods: o 50/50 Method (default rule) 12

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Allocate half of GI to production and half to sales Portion allocated to production is divided b/w US source and F source based on the AB of productions assets located inside and outside  The sales half is sourced based on title passage rule o Independent Factory Price (IFP)  TP can elect to base allocation based upon an IFP that is “fairly established” by sales to unrelated parties (this allows you to determine actual production cost) Depreciable or Amortizable Personal Property  865(c) – Recapture Rule  Gain from sale of depreciable or amortizable personal property will be US source to extent that deductions were previously allocated against US source income  If depreciation deductions are taken against both US and F source, recapture will be allocated proportionally o If the gain exceeds depreciation, then rules for inventory property apply to the excess  Ex: F person buys an asset for $100 which produces 50% US source income and 50% F source income  Depreciation of $50 taken, and then sold for $125  Of the $75 gain: $25 will be USSI; $25 will be FSI, $25 will be under title passage rule Gain from Sale of Intangible Property  General rule – sourced to residency of seller  Three Exceptions:  (1) Contingency: where a IP can be hared to value, if the sale is based on a contingency  royalty rule  (2) Goodwill: sourced to place of creation  (3) Amortization: must apply recapture rule of 865(c) – after recapture, remainder of gain is under residence of seller rule Sale of Property vs. Royalties  RR 84-78: A patent for the rights to show a boxing match is sold. Payment from a F company to a US company. Two fact patterns: one is non-excluive right and one is exclusive right for limited duration.  Ruling states that both are F source under the royalty rule o Note: we did not sell enough to put us into the sale of personal property  You don’t have to sell the whole IP right to fall in the sale of personal property rule o You can limit the right geographically or by field of use (i.e. under certain medium)  BUT, whenever an IP right is sold that is limited by time, it will always be under royalty rule Gain from Sale of Stock in Foreign Affiliated Corp

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Section 865(f): sale of stock by a US corp in a F “affiliate” (80% vote and value) corp  If the sale occurs in the country in which the affiliate conducts an active T/B and more than 50% of its GI during a base period (3 years prior to sale) is derived form active conduct of T/B in that country (i.e. 50% active F income), then gain will be F source (even though a US corp is selling)

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Alimony o No specific rule o General approach when no specific rule exists is to look for the class of payment that looks most similar  Most rules look for an economic nexus (exception for interest (sourced to payor) b/c not paid in exchange for property or services) o Same for alimony – not paid in exchange for property or services o Source rule – source to residence of payor o Makes sense in same way that CNC source rule is justified – the payor will be getting the deduction in his J  alimony payment should be sourced to same J Source Rules for Deductions o To determine FS and USS income, must determine what deductions should be taken against each  F persons are taxed on net income of US T/B o General Rules  861(b), 862(b), 863(b) – from items of GI from within US [or without] there shall be deducted expenses, losses, and other deductions properly apportioned and allocated  Reg 1.861-8: Amounts of deductions must be charged against the USS and FS GI based on a factual relationship b/w the income and the expenses  Two Step Method: Allocation and Apportionment  Allocation: Particular deduction in question must be factually attributed to some “class of GI” on a worldwide basis  Allocation = fact specific; direct connection to a “class of GI”  Apportionment: After allocated to class, deduction is apportioned b/w the appropriate statutory grouping and residual grouping  Apportionment = formula; splitting the deductions across different parts of the classes of GI  Apportionment = determining the taxable income on each side of the US and Foreign line  Regs do not mandate a particular method of apportionment, but suggest possibilities such as units sold, expenses incurred (e.g. salary), and gross income  Class of Gross Income: based on classes in Sec 61 (may need to even subdivide each class)  Statutory Grouping: Chunk of GI that we care about under the operative section (i.e. if we are talking about inbound taxation, then 871(b)(1) or 882(a), for outbound, it will be 904)

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The operative section will say “taxable” income – but to get there, must first start with “gross” income  Residual Grouping: everything else – all GI that is not in statutory group o Interest Expense – Special Rule  Proper allocation is troublesome b/c money is fungible  most loans in a sense contribute to financing all of TP’s activities or assets  864(e)(2): “all allocations and apportionments of interest expense shall be made on the basis of assets rather than gross income”  Asset Method: TP apportions interest expense to the statutory grouping fo GI on basis of average total value of assets within the grouping (may use tax book value or FMV)  Example: Assume US corp has a F branch and wants to finance something in the F branch with debt  Loan generates interest expense, but since paid by US corp  US source INBOUND TAXATION: FOREIGN PERSONS WITH DOMESTIC SOURCE INCOME Domestic Business Income (Income Effectively Connected to US Trade or Business)  Introduction o A F person’s US tax liability depends on whether the income is derived from US sources and whether the income is passive or effectively connected to a US T/B o Four topics re: Inbound Taxation:  (1) Whether TP is engaged in a U.S. Trade or Business (ETB) – 864(b)  (2) Whether TP’s income is effectively connected income (ECI) – 864(c)  (3) Application of Treaties  (4) Branch Profits Tax Engaged in US Trade or Business o “Trade or business” = process of producing or seeking to produce income from actively engaging in business activities (vs. merely owning income-producing property)  A F person will be found to have a US TB if there are regular, continuous, and considerable business activities in the US  Note: there does not actually have to be a US situs for the US TB  There is no actual definition of “US TB” – must rely on judicial authority and Revenue Rulings too o Performance of Personal Services  864(b): “the performance of personal services within the US at any time within the taxable year” = USTB  De Minimis Exception – 864(b)(1) – NRA present in US not more than 90 days and receives no more than $3000 o Exceptions to US TB: Trading in Stocks, Securities, or Commodities  The following safe harbors allow F persons to invest in US without being subject to US tax

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864(b)(2)(A) – A F person, including a dealer, may trade in stock or securities through a resident broker, commission agent, etc. without establishing a US TB  A F investor may trade for investor’s own account either directly or through employees, resident brokers, etx  Safe harbor is not available to dealers  As long as TP is not a dealer, then TP can engage in fair amount of trading and won’t be subject to US tax  A dealer can engage in trading, but only if he does not have a US office o Engaged in US TB: Direct vs. Indirect  Direct: TP himself is performing the activity  Indirect: another person is performing activity which will be attributed to TP (usually through agency or p-ship) o Continental Trading, Inc. v. CIR (9th Cir. 1959)  Continental (TP) has two lines of activities: a large investing activity and a much smaller dairy activity  The TP wants to be considered a US TB in order to receive deductions (much income from US investments) – usually it’s the opposite  Investing business  definitely not a US TB (Higgins)  Issue: whether the Dairy activities give rise regular, continuous, and considerable activity in the US  There were three types of dairy transactions, but to of them were just one-off transactions – the third transaction was purchasing and reselling milk cans with a 5% mark up  For the years in question, TP did it 37 times and 48 times  US TB? o Seems that it is considerable enough to meet threshold o Also seems that there was a business prupose  Court disagrees – holds no US TB  Court basically looks at activities in an aggregate approach or in context: o The investing business was so large that even when considering continuous nature of dairy business, it stil does not compare  On one hand seems right: no deductions just because TP engaged in some transactions that were insubstantial when compared to whole business  BUT, if it would have been continuous enough for a TP only engage in dairy business the treatment should not be different  Affirmative Use of Continental:  On the other hand, when a TP wants not to be engaged in a US TB, he can just pack in enough stuff that is not connected with the US o Inverworld, Inc.  Cayman entity (LTD) holds US Holdings which holds US Inc. Mexican investors are putting money into LTD which ultimately gets invested in US.  Issue: whether LTD is engaged in US TB  Yes  TP’s argument:

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They have two businesses: o (1) advising the investors – this is the main business and it occurs in Cayman entity o (2) access to the US markets – the entity needs to provide this b/c controls prevented Mexicans from investing directly  TP argues “access” business is not substantial enough to make it into a US TB  Gov’t argument:  Agrees that there are two businesses, but argues that the “access” is really the main business  Court holds that the US activities are enough to make it a US TB, but the case also seems to support affirmative use of Continental:  Court uses the words “real business”  they are looking in an aggregate basis to see which is the real business, rather than just looking to see if the US activity passes the threshold  Court adopts the qualitative and quantitative approach to assessing the US activity from Scottish American:  In Scottish American, the TP was an F investment trust with a US office and issue was whether the US office was engaged in a US TB  Court looked to see what the “real business” of TP was, i.e. that which they were principally organized to do and realize profit  court decided that the real business was the management of Scotland and British capital and the activities in the US office were “merely helpfully adjunct”  “In cases such as threes, it is a matter of degree, based upon quantitative and qualitative analysis of the services performed, as to where the line should be drawn.  Court also looks at European Naval Stores  A Belgium importer buys goods from US seller (this alone is not a US TB)  During WWII, sale is executed, but goods are unable to be delivered – US seller decides unilaterally to buy the goods back – IRS then claims that Belgium importer is engaged in US TB b/c now buying and selling goods in US  Court holds that qualitatively it is not enough to = USTB o RR: NRA enters a racehorse into one US race and horse wins. Qualitatively, the winnings were high percentage of horse’s earning potential, but one race was small number compared to all races.  Service took position that it constituted US TB o Agency Arrangements / Indirect ETB  Use of agents or representatives in US by F person does not automatically establish a US TB  The determination is based on the functions and activities performed by the agent and the relationship with the TP  RR 70-424

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M (FC) grants Q (DC) the sole agency for sales of its products within the US. There are some restrictions on what Q can do (basically noncompete arrangements).  Held: the arrangement is one of principal and agent in which M carries on its US activities through Q  all activities of Q are attributed to M  M is engaged in US TB o But, compare to Handfield  Handfield v. CIR  Issue: whether TP (Canadian NRA) is engaged in US TB  TP produced post cards and “sold” them to ANC who distributed them to final customers  TP claims that he has a buy / sell relationship with ANC and therefore no US TB o Simply selling into the US is not a trade or business  But court disagrees and believes it more to be a US agency relationship  activities of ANC are attributed to TP  pushes him over the threshold to be engaged in US TB o ANC had no obligation to purchase the cards and would send back unsold cards to TP  no risk o The retail price that ANC sold for was set by the contract  no control  When there is no risk and no control on ANC’s part, it’s very easy to conclude that they are really an agent o Indirect ETB via Partnerships, Trusts, and Estates  P-ship operations are attributed to the respective partners for tax purposes  If the p-ship conducts a US TB  each partner deemed to be engaged in US TB  However, that still leaves the question of whether the p-ship is engaged in a US TB  US v. Balanovski  B and H are partners in CADIC. B owns 80%. B’s role is to find suppliers in US and ask if willing to sell a product for X dollars. If supplier agrees, B forwards to H and H forwards the offer to sell to Argentina gov’t which includes a mark-up.  The Dist court below found that only B was engaged in US TB – the p-ship and H were not  Issue presented to 2nd Circuit: should the p-ship be ETB by virtue of the activities of its 80% partner (if so, then both B and H are ETB) o Normally, you cannot establish a US TB just by purchasing in US – but court believes that both the buy and sell is actually occurring in the US  Court holds that p-ship is engaged in TB  Note: this is before passage of title rule – case would be moot in light of that rule b/c TP would just manipulate to pass title outside US o Management of Real Property

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Ownership and rental of real property does not necessarily constitute T/B, but FP might try to characterize as such in order to get deductions  Lewenhaupt: NRA had LTCG on sale of property in US. TP argues that he is not ETB (wants FDAP so that it is exempt via treaty). Court holds that TP was engaged in TP based on regular, continuous, and considerable activities of an agent that included: mgmt and operation, executing leases, collecting rents, keeping books.  Such activities were beyond the scope of mere ownership and receipt of income from real property  RR 73-522: where TP owned real property in US and rented it out via “net leases” (tenants paid all expenses), TP was not engaged in US TB b/c only activity was spending one week to negotiate leases  Election:  If TP does want deductions, then code allows F person to elect to be treated as if engaged in US TB with respect to all of its US real property held for production of income Determining the Amount to be Taxed (ECI Income) o Income Items – The “Effectively Connected” Principle  Old “Force of Attraction” Doctrine – any FP that conducted a TB in US would be taxed at usual rates on all US source income – whether or not connected to business  Now we separate ECI and passive income  Statutory Map  871(b) – NRA engaged in a US TB will be taxed under sec 1 or 55 on his taxable income that is effectively connected with the US TB  882(a) – F corp engaged in US TB will be taxed under sec 11 on its taxable income that is effectively connected with the US TB  To see which income items are “effectively connected”  864(c)  864(c)(2) prescribes factors for determining whether US source income is ECI:  (1) Asset Test: did the income derive from assets used in or held for use in the conduct of T/B  (2) Business Activity Test: did the activities of the T/B constitute a material factor in the realization of the item  All ECI is combined for determining FP’s tax liability (losses from on T/B can offset gains from another T/B)  Asset Test  A direct relationship b/w the asset and the T/B will be found only if the asset is held to meet the present needs of the T/B and not its anticipated future needs  Ex: F mfger co has a US branch (assume threshold for US T/B is met) o The company produces golf balls (seasonal) and also holds securities which pay interest o Issue is whether the interest is ECI o If company is using interest to offset the slow period = current use  ECI 19

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o If company holds securities b/c it wants to later diversify = future use  not ECI Business Activities Test  This test is used to distinguish active conduct of business form normal supervisory functions of an investor (e.g. dividends or interest derived from dealer, gain or loss from exchange of stock)  Best example = banks o The interest they earn clearly falls in this test  ECI  RR 86-154: o Reg 1.864-4(c)(5) provides special rules for determining whether income from securities (interest) is ECI with the conduct of banking, financing, or similar business within the US  The securities must be considered attributable to a US office through which the banking business in carried on  A security is attributable to US office only if such office actively and materially participates in soliciting or negotiating or other activities required to acquire the loan  Note: The US office need not be only participant o On the facts, case where US branch is active in acquiring the loan  ECI o But where F Parent approves a loan to its US Sub and merely funds and service the loan through the branch  not ECI “Residual” Force of Attraction – 864(c)(3)  Any items of USSI not covered by 864(c)(2) will be attributed to the US T/B even absent an actual connection o Essentially, all income comes in, but there are exceptions  Inventory – comes into ECI o Ex: Assume a F corp is trying to sell goods into the US market (most likely requires some sort of US presence). The F corp has the ability to manipulate source (pass title abroad)  F source income. Idea is to catch some of this as ECI and  865(e) – Special source rules for sales through offices or fixed place of business o 865(e)(2) – Sales by non-residents  (A) if a non-resident maintains office or fixed place of business in US, income from any sale of personal property attributable to such office = US source  (B) Exception: the property is used outside the US and a foreign office participates in the sale o 864(c)(5) – Rules for establishing whether F TP has office or ETB  (A) the office of FPB of an agent of the TP is disregarded unless the agent has authority to negotiate

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and conclude contracts in name of F TP and regularly does so  Potential Trap: A F corp without a US TB sells to a US buyer certain goods. Title passes in US, but no US presence so US cannot tax it. But then US buyer needs training with the goods so they enter into a service contract with F corp. Performance of services in US = US TB (864(b))  Always ECI. Now, once there is a US TB, residual force of attraction rule applies and the income from the sale also gets included  Certain F Source Income will be ECI – 864(c)(4)  F source income generally not treated as ECI, but some exceptions exist and subject it to US taxation  F source income from gains and losses may be deemed ECI if two requirements are met: o (1) TP “has an office of fixed place of business in US”, and  Office or FPB determined under 864(c)(5) o (2) The “income is attributable to that office”  Materiality test – the office is a “material factor’ in realization of the income  Office must provide significant contribution to, by being an essential economic element, in the realization  Under 864(c)(4), there are only three types of F source income that will be considered ECI o Rents and Royalties from Active Business  Assume F corp operates a research facility in US and licenses the technology abroad - even F source royalties = ECI o Dividends and Interest from Active Business  A US branch of F bank loans money to F person – the F source interest will be ECI o Sale of Inventory Property through US office  Almost never applies because exception of source rule changes it to USSI  Only way to have it not be ECI is to have a F officer materially participate and foreign use of the property  Other items of ECI  864(c)(6) – Deferred Income – deferred payments (installment sale) will be treated as ECI if they would have been so in the year of the transaction (i.e. if the TP no longer has an ETB)  864(c)(7) – Depreciation Recapture – property formerly used in US T/B disposed of within 10 years of such use  gain is taxed as if still used in connection with T/B o Deductions and Credits Applicable for ECI  Now, once we have all the items of ECI, the goal is to get from gross to net  Under 873  use Allocation and Apportionment  Interest Deductions = most problematic

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Current approach is that allocation and apportionment of interest expense should be made on basis of assets rather than GI o Rationale: loan proceeds help finance all assets and activities  Scenario 1: F Co (not a bank) is in business of equipment leasing. It has $100 cash and $100 retained earnings. F Co borrows $100 and pays $10 interest. F Co has a US branch and a F branch. Both branches rent a US crane out for $100 that provides a stream to F Co. o Since money is fungible, must treat the debt as financing both branches equally  $5 deduction against both the US source rental income and the F source rental income  Scenario 2: F bank with a US branch. F bank receives $100 demand deposit (pays not interest). US branch has a $100 CD and pays $10 interest expense (legally incurred by F bank. o The fungibility argument does not hold and it could be argued to deduct full $10 interest against US source  Reg 1.882-5 provides rules for dealing with such problem Effect of Tax Treaty Provisions o Introduction  Treaties can affect the US taxation of F persons engaged in US T/B (they may impose lesser taxes then code, but will generally not increase the burden)  Therefore, an F person would attempt to claim the benefit of a treaty b/w his country and the US (treaty is optional)  The treaty terminology is analogous:  Permanent Establishment = ETB  Attributable Profits = ECI  Business  ETB  PE  Article 5  ECI  Attributable Profits  Art 7  Individuals  Must distinguish between Independent Services (IC rather than employee) and Dependent Services (employee)  Independent Personal Services o ETB  Fixed Base  Art 14 o ECI  Attributable Profits  Art 7  Dependent Personal Services o More generous threshold: A F employee can be in US less than 183 days and make any amount of money and treaty will preclude taxation, provided the income is paid by a F employer o US Trade of Business Income – The “Permanent Establishment Provision”  Tax treaties provide more predictability of when income from a US TB will be taxed by US (i.e. more predictability about when threshold is met)  “Business profits” will not be taxed within US unless the F person carries on a US TB through a “permanent establishmet” to which the “profits are attributable”  Article 5 (Model Treaty) – Permanent Establishment (p. 1055) 22

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5(1): A PE = fixed place of business (“physical aspect” that doesn’t exist in ETB analysis)  5(2): PE includes place of mgmt, a branch, an office, a factory, etc (non-exclusive list)  Safe Harbors: instances where there may be a FPB, but US will not tax (policy reasons) o 5(3): building sites and such that exist less than 12 months o 5(4): other places that won’t be deemed PE  Use of facilities solely for storage, display or delivery; carrying on any activity of a preparatory or auxiliary character  Aggregation allowed – no matter how many activities you do that are allowed under 5(4) (auxiliary and preparatory), it will never establish a PE  PE through Agents o 5(5): When the F person employs a dependent agent it is difficult to avoid establishing a PE  When an agent has authority to enter binding contracts, the F person will be deemed to have a PE  This would be an agency PE (no need of a FPB in this case)  Hence, two types of PE: Agency PE and FPB PE  Only way to avoid PE with dependent agent is to strip the agent of binding authority (have all decisions go through head office) o 5(6): When F person employs an independent agent, then it is good for avoiding a PE  Independent agent must be acting in the ordinary course of its own business  Risk and Control: greater risk and control in hands of agent will lead to non-attribution (no PE) Simenon v. CIR (1965) (PE through FPB)  TP (F person) was an author and converted 50% of his US residence into an office. Under the treaty, all of TP’s royalty income from US would be exempt from US tax if no PE existed o TP was in US until Mar 19 – he then returns to France – at some point he receives US royalties  Issue: whether TP had a PE in the US  TP’s status is that of NRA. He is clearly engaged in a US TB for the time that he is in US. He receives US royalties = US source. It is passive income, but it seems that it would be ECI under 864(c)(2)(B) – the business activities test. o Therefore, TP has ECI that should come into US tax base, unless he can claim the treaty, which requires that there be no PE.

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TP’s argument is that the home office has no “business” aspect – only a “creative” aspect where he gets his thoughts o But argument undercut by fact that TP takes depreciation deductions on 50% of the house  Court finds that TP’s activities as an author = carrying on of a business (he actively marketed his work)  PE established  Tasei Fire and Marine Insurance Co. (No PE through Agency)  TPs are Japanese reinsurance companies (F persons) who are dealing with Fortress, an unrelated US company. The TPs are making money from contracts that Fortress is soliciting.  Issue: whether an agency PE has been established by TP’s use of Fortress o Issue turns on whether Fortress is a dependent or independent agent  In order to have an independent agent, need two things: legal independence and economic independence o Legal Independence: Fortress is soliciting the deals on its own, not being controlled by TP o Economic Independence: Payment is contingent on what Fortress finds and is in line with the work done  Court holds that Fortress = independent agent  No PE o Attributable Business Profits: US Tax Liability on Operation of PE  Items of income that are attributable to the PE will be included in F persons’ gross income  Business Profits: allows for deductions  net income  Attributable profits essentially = ECI, but two exceptions  (1) Only profits linked to assets or activities of the PE are included o No residual force of attraction  (2) Must use separate entity principle o Income attributable will be business profits that PE would have if it were distinct and independent enterprise engaged in same or similar activities under same or similar conditions  National Westminster Bank, PLC (1999)  Case examines the “separate entity principle” and trying to determine the appropriate interest deductions taken against the attributable profits.  TP is UK Bank with a US branch. The US branch has $140 of total assets: $60 loan from the Parent, $40 loan from a third party, and $40 cash. o On the loans, the US branch pays out 10% interest for total of $10 deduction.  IRS argument: the $10 deduction is too large – suspicious of interbranch loan  Reg 1.882-5: Steps for determining allocation of interest deductions o Step 1: Determine value of all “US assets” that generate ECI $100 24

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o Step 2: Determine the “deemed liabilities” (what is the appropriate amount of leverage)  TP can use either the leverage of the Parent (amount of worldwide liabilities) or standard percentage for banks (93%)  Therefore, branch is deemed to have $93 of liabilities o Step 3: The 3P loan ($60) is not suspect – back it out - $33 remaining o Step 4: TP gets $6 interest expense for 3P loan and $3.3 for the intercompany loan o Relation of Treaty to Code Provisions  Sometimes the regular rules will produce certain results that are more favorable than the treaty  An F person can elect whether to exercise treaty rights, but cannot elect to have some US business activity under a treaty and other under the Code  RR 84-17 exemplifies this (where an F co had a PE make and sell Product A for a Gain, and IC sold Product B for a gain, and an IC sold Product C for a loss) Branch Profits Tax (Sec 884) o Before BPT, when an F corp holds a US branch vs. a US sub, there is a difference in the tax  Both would be taxed on net income, but a dividend from the US sub would be subject to a second tax (30% WH tax to F corp under FDAP rules) o BPT imposes a second tax (in addition to tax of 882) – imposes a withhold tax of 30% on the “dividend equivalent amount”  Idea is that there are earnings in the branch and it moves out of the branch, it gets taxed; if it stays in the branch, then no tax o Dividend Equivalent Amount (DEA)  DEA is calculated with respect to effectively connected E&P  Same meanings as we are accustomed to – to determine EP, start with taxable income and make adjustments  DEA starts at “Effectively Connected EP” amount and you assume all will be distributed up  If branch equity increases (i.e. nothing is being removed), then DEA decreases (branch equity measured by adjusted basis of assets) o DEA = EC EP – any net increase in investment in US branch o Note: DEA cannot drop below 0  If branch equity decreases, then DEA increases o DEA = EC EP + any net decrease in investment in US branch  BPT = DEA x 30%

Domestic Non-business Income (FDAP)  Basic Mechanism o Tax on Gross Income

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Sec 871(a), 881(a): Most of the US source income received by F person not ECI with US T/B (FDAP) will be subject to flat ax of 30% on gross amount  1441, 1442 impose withholding  FDAP income = “interest, dividends, rents, salaries, wages, . . . and other fixed or determinable annual or periodic gains, profits and income” o Rationales for Tax on Gross Income  (1) Necessity: F persons are earning passive income so it can be difficult to find and enforce tax on them  (2) Close to Accurate: intended to approximate the tax burden on net income without complicated formula  Since it is passive, there likely is not much expenses associated What is FDAP Income? o Capital Gains =/= FDAP  We’re looking at F persons: when property sold, source to the residence of seller  F source income  Exception: 871(a)(2) – if F person has been in US more than half the year (but this might make them a resident) – only time exception applies is when you are in US more than half year, but not enough under substantial presence test o Inventory =/= FDAP  Statute is unclear, but regs say that sale of inventory =/= FDAP o CIR v. Wodehouse  Author (TP) received lump sum payment from publisher for exclusive book rights throughout the US. TP argues that this is a sale of a copyright. But Service argues that it’s not a sale, but rather a royalty that is covered by FDAP  TP argues that since the payment is a lump sum, it is not annual or periodical  Court holds that it is a royalty and subject to FDAP 30% tax  Just because he received one payment rather than spread out does not allow TP to avoid the taxes  Court is saying that an FDAP item does not necessarily need to be “annual or periodical  BUT, it still always must be “fixed or determinable” (TP needs to know what amount to include) o Central de Gas de Chihuahua, S.A. v. CIR  Two Mexican companies (Hydra and Chi) were under common control. Chi allows Hydra to use a fleet of trucks, but there is no payment. Service imputes a deemed rental payment under 482.  Issue: whether the deemed payment is in FDAP regime and subject to withholding tax  TP’s argument is that you cannot withhold a tax from a payment that was never made  Court holds that the fair rental value of the equipment is subject to withholding tax even though payment was never made Untaxed Items of US Source FDAP Income (outside of both ECI and FDAP) o Certain US Source Interest

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Interest on Certain Bank Accounts  871(i) and 881(d) exempt interest on certain deposits from the 30% tax even though it is US soure o Rationale: to encourage F persons to use US banks and savings institutions  But Note: kicking it out of FDAP shouldn’t really change anything – the F person pays tax on the interest in the F jurisdiction. He most likely received a credit for the US tax paid on the interest. When the US tax on interest is removed, so is the credit  F person still pays the same amount. o The reason it makes US banks more competitive is because the F tax is really not being collected (F person most likely cheating – earning and not reporting)  Portfolio Interest  871(h) and 881(c) eliminate 30% tax on interest from “portfolio debt investments”  Basically same rule, except the interest is earned by bonds rather than deposits  Exception: if F person holds more than 10% of the issuer o Certain Dividends  If the US corp earns 80% or more of its GI from F sources as result of F TB, a portion of the dividend will not be subject to the WH tax  Untaxed portion of dividend = percentage of GI from F sources for three year period prior Effect of Treaties on Withholding Taxes o Withholding Tax on FDAP Income  Treaties generally provide for reduction or elimination of WH taxes of specified items of US source FDAP income  Model Treaty: WH taxes on interest and royalties eliminated; dividends reduced to 50%  Art 11 - Interest o “Shopping” For Treaty Benefits  Typical structure: US corp establishes a finance sub in a treaty country that exempts US source interest  Finance sub issues bonds in F market – proceeds of the bonds are loaned back to the parent and the US WH tax on the interest is exempt o Defenses Against Treaty Shopping Abuses  Three types of defenses: Judicial Doctrines, Administrative Authority (AntiConduit Regs), Treaty Provisions (Limitation of Benefits Clauses)  Invoking Judicial Doctrines  IRS has argued that the finance corp b/w the “true” borrower and lender should be disregarded b/c no substance  argument has failed  IRS had better success arguing that F corp interposed into a treaty should be treated as a conduit and not get benefits of the treaty  Aiken Industries v. CIR o Before Structure (which was inefficient for Aiken): 27

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Aiken (US corp) held ECL (Bahamas Sub) and Industria (Honduras Sub)  Loan (2.5M) from ECL to Aiken and interest paid by Aiken to ECL  No treaty b/w US and Bahamas – so interest payment bears a 30% tax o After Structure:  ECL transfers 2.5M note to Industria in exchange for 9 note of $250,000 (had to send something to avoid 482)  US has treaty with Honduras, so now interest payments exempt form tax  Industria has interest coming in, but it has exactly offsetting deduction paying to ECL  The interest going to ECL = not subject to any withholding and ECL is in tax haven so no tax o Gov’t makes two arguments: Sham Entity and Conduit  Gov’t loses on sham entity and court chooses to recognize it as actual entity  Gov’t wins on conduit argument because there was exactly offsetting income coming in and flowing out Invoking Administrative Authority  Netherlands was tax haven b/c US had a treaty with them – due to excessive exploitation, IRS had to act to deny benefits for certain finance sub arrangements (eventually treaty was terminated)  RR 84-152: o P (Swiss Co) owns both S (Netharlands Sub) and R (US Sub) o Goal is to get capital from Swiss Co to US sub – done via a financing intermediary (S) which will make a spread o P lends to S capital at 10% and S reloans the proceeds to R at 11% o Absent, treaty there would be WH tax on the interest paid by R – but treaty says that interest paid from a US source to a Netherlands corp without PE shall be exempt o Held: Interest is treated as goiong from US Sub to Swiss Co and the S is ignored  S was merely a conduit and never had complete dominion or control over such payments  Use of S lacked sufficient business or economic purpose  Northern Indiana Public Service v. CIR o A similar structure where interest was flowing from Netherlands Co to a US o Court holds that Netherlands sub was not a conduit  Reconcile Aiken, RR 84-152, N. Indiana o Aiken: clearly no control or dominion – exactly offsetting

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o RR 84-152: Became a common structure after Aiken and Service announces that 1% spread is not enough to escape conduit o N. Indiana: more complicated structure where it is harder to tell if something is happening inside the sub Anti-Conduit Regs  Regs allow a “recharacterization” of multiparty financing transaction if such is appropriate to prevent avoidance of tax o Essentially disregards the intermediary entities and treats the payments and interest as going between F parent and US sub  Address three- party structure: o F1 parent holds F2 sub and US sub. TP (F parent) wants to deploy capital into US and wants to get the returns back without paying 30% WH tax (i.e. put in capital and get equity back without paying tax on the dividends or make loan and not pay tax on the interest)  Two requirements for Regs to apply: o (1) Participation of an “intermediary entity” in a “financing arrangement”  Advance of money or property from financing entity to the financed entity through an intermediary o (2) The intermediary must be a “conduit entity”  Conduit Entity requires:  (1) Participation of entity reduces tax under 881  (2) Tax Avoidance Purpose  (3) Intermediary is a related entity  Regs are narrower than Aiken b/c of Tax Avoidance Purpose requirement, but broader because applies to any financing arrangement (loans, leases) o If it was a back to back lease of equipment and the Regs apply, the rental would be deemed b/w F parent and US sub Limitations on Benefits Clause (p. 1067)  Art 22 of Model Treaty is a common (but contentious) provision that will prevent some residents (mainly corps) from claiming the benefit of the treaty, unless they qualify by falling into one of the provisions  2(a): an individual can always claim the benefits  With corps, the LOB clause is looking at what a corp might try to do in order to get the treaty benefits  Three ways that a corp can claim the treaty o 2(c): Recognized Exchange  A F corp can claim the benefits of a treaty with respect to receiving US source payments if more than 50% of the F corp’s shares are traded on a recognized exchange  Or 50% of shares are owned by companies entitled to the benefits of the treaty 29

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o 2(f) Ownership / Base Erosion  If for at least half of the taxable year, at least 50% of the corp is owned (directly or indirectly) by a person entitled to the benefits of the treaty under the above provisions, AND  Less than 50% of the corp’s GI is paid out as a deductible expense to non-residents (people who can’t claim the treaty)  This provision is getting at whether the owners of the corp themselves are residents of treaty country o 3: Trade or Business  This provision looks at the activity of the entity  Three requirements: (1) entity must be engaged in T/B; (2) the income must be connected or incidental with the T/B, and (3) the T/B must be substantial in relation to the activity in the other State generating the income  Note: Making of investments/loans only counts as active T/B for banks and other listed financial institutions Anit-Conduit = transactional approach vs. LOB = entity approach o A F entity might pass LOB test, but then get denied the benefits under the Anti-Conduit regs

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Withholding o Section 1441 and 1442 govern WH taxes, but the rules are mostly in the Regs o Basic rule: a person in control of a payment to a F person that is subject to WH must WH 30% (or the applicable rate)  WH agent could be personally liable if he does not withhold the tax FIRPTA (Foreign Investor in Real Property Tax Act) o Not a T/B issue, but rather a question of whether gain to an F person from sale of real property in the US gets sucked into FDAP  Without FIRPTA, if a F investor sold US real property it would be considered capital gains which are not FDAP when TP is not in country for 183 days o Regime:  Applies to any “US Real Property Interest” – broad, refers to any inherently permanent structure  Also applies to “US Real Property Holding Corp” – if you have real property held in a corp that is held by an F person, the sale of the shares will be subject to the regime  USRPHC = corp which US real property interests exceeds 50% of the FMV of the corp  If F person falls within the regime, he is treated as if he had a US T/B  net basis taxation  ECI o Avoiding FIRPTA: F person could create a holding company with its US real property and pack enough other stuff into it so that it is not a USRPHC Financing the US Enterprise o Debt v. Equity

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When F investor operates through separate US sub, same issues of whether to finance with debt vs. equity come up  If the US sub is too thinly capitalized, then interest and principal payments going back to the F parent may be treated as distributions  dividends will not be deductible and WH tax will apply o Earnings Stripping Provision – 163(j)  Even when debt is not recharacterized as equity, 163(j) may limit the deductibility of interest  Applies to payments made to a related TP with no US income tax liability (e.g. loans made by F SHs to corp where treaty exempts the interest paid to F SHs)  Structure: F parent holds a US sub. The F parent will favor debt capitalization. The payments from US sub are deductible.  This is a inbound issue, but the tax we care about is the liability of the US sub  Note: if it was a US Parent, we don’t care that the sub gets the deduction because it is offset by the interest income coming into the US Parent o But with F parent, it is not taxed and there is some amount of profit being passed up and not taxed (“earnings stripping”)  163(j) will disallow the deduction if it is a “disqualified interest expense”, but will be capped at “excess interest expense” and only if debt to equity ration is too high  Excess interest expense: the amount of interest expense greater than 50% of corp’s taxable income  Ratio too high: greater than 1.5 OUTBOUND TAXATION: US PERSONS WITH FOREIGN SOURCE INCOME The Foreign Tax Credit  Introduction o US generally taxes US persons on WW income o Decision of whether to use a branch or F sub to conduct business abroad  Issue is one of deferral – US person is not taxed until the profits are repatriated when it is a F sub  But US person would lose benefit of deducting losses  Subpart F will put limits on deferral o Foreign Tax Credit is about mitigating int’l double taxation o Outbound vs. Inbound:  For inbound, tax on F persons, you start with $0 tax baseline and try to build up by bringing items of income into the base  For outbound, tax on US persons, we presume that all F source income is subject to tax and then carve it back Overview of the Foreign Tax Credit o Without an appropriate adjustment, double taxation would inhibit international trade

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o TP is entitled to a credit for the amount of F tax paid, subject to the limitations o General Limitation: US Rate x F source income  The game is to move US source income (passive) into a F jurisdiction and make it become F source  increases F source income  increases the limitation o What is a “tax”?  In order to credit to apply, the F tax paid must be a “tax” and the predominant character must be that of an income tax in US sense (e.g. realization based, gross concept, net basis)  It would be in the F gov’ts interest to call something a tax so that it will be creditable o Conceptual Examples  General Limitation: Assume US rate is 35% and F rate is 40%. US TP has $100 of US source income and $100 F source income.  $100 US source  $35 tax  $100 F source  $40 tax to F country; $35 tax to US  TP gets credit of 35% x $100 = $35  The general limitation prevents the extra $5 paid to F country from crossing the line and offsetting the US income  Aggregate rate = 37.5%  Separate Limitations: Same facts above, but now there is a F2 tax haven involved. Assume US rate 35%, F1 rate 40%, F2 rate 0%  Move $20 of the US source income into F2  $80 US source  $28 US tax  $100 F1 source  $40 F tax; $35 US tax  $20 F2 source  $0 F tax; $7 US tax  FTC will credit 35% x $100 = $35 credit The Indirect Credit (Section 902) o The FTC could lead to disparate treatment b/w a sub and a branch:  When a US TP has a F branch, it is just one US tax base and the US TP will be entitled to a credit for F taxes paid  But, when US TP has a F sub, the sub pays F taxes. Therefore, when it distributes a dividend to its US parent, the parent is taxed on the dividend  Sec 902 gives an indirect credit: when a sub’s earnings are distributed to US parent as a dividend and US tax liability arises for the first time, 902 treats the US parent corp as if it had paid a share of the F taxes actually paid by F sub o Indirect credit applies only to a US Corp SH AND only if it meets a voting ownership requirement  Ownership requirement = 10% of the voting stock of the F corp at time of dividend distribution  902(a): corp SH shall be “deemed to have paid” the same proportion of the F corps’ post-1986 F income taxes as the amount of the dividend bears to F corp’s post-1986 undistributed earnings o Six Step Methodology for Calculating 902 Deemed Paid Credit:  (1) Threshold Tests: Corporate Status and 10% Ownership  Corp SH must own at least 10% voting interest in a F corp 32

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(2) Amount of Taxes Deemed Paid:

Gross Dividend Paid to Taxpayer * Foreign Corp’s Post-1986 Foreign Taxes Foreign Corp’s Post-1986 Earnings  Remember to decrease F corp’s earnings by the amount of taxes paid  Gross dividend ignores WH tax withheld  (3) Amount of Dividend Included in Gross Income: equal to the gross dividend plus the “section 78 gross-up”  Gross Dividend + Amount from Step (2)  (4) Tentative Tax:  Amount from Step (3) * US Corp’s tax rate  (5) Allowance of Credit: US Corp’s liability is equal to the tentative tax less the foreign tax credit:  Amount from Step (4) – Amount from Step (2) (BUT subject to general and separate FTC limitations) o Also remember to subtract any direct credit (i.e. amount withheld on dividend)  The result gives you the total tax liability of US corp  (6) Update Earnings and Tax Pools  F corp’s Post-1986 Earnings Pool is decreased by the amount of the gross dividend (ignoring 78 gross-up) and the F corp’s Post-1986 Taxes Pool is decreased by the amount of F taxes attributable to the gross dividend paid to all TPs (i.e. other SHs) Adjusted pools form basis for calculation next year.  This is basically reflecting that dividends were paid out  Earnings pool is adjusted downward by amount of dividen  Tax Pool is adjusted downward by: o (Amount of dividend to all SHs / Earnings) x F taxes paid o The idea is that if all of the earnings get distributed up, then US parent should get credit for all the F taxes paid  The total tax bill for the US should be 35% on the F earnings o Section 902 Concepts:  The heart of the Indirect Credit is the “Deemed Paid Credit” fraction: when you distribute all the earnings the formula = total F taxes paid  Rewrite the formula to  (Taxes Pool / E Pool) * Dividend  The larger the fraction, the larger the deemed paid credit  Fraction = effective tax rate for the F jurisdiction  This tells you that given a the choice, a US parent would rather have a sub in a higher rate J pay up the dividend then a lower rate J o Indirect Credit Through Multiple Tiers  The indirect credit is also available to US parent on dividends paid up from a F second tier sub to a sub and then to a parent (or longer chain)  Requirements:  Ownership test must be met at each level and multiplying all ownerships must be equal to 5% or greater 33

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Mechanics:  Maintain an E Pool and Tax Pool at each level  Each time a dividend is paid up, treat the recipient as if it was a US company claiming the credit (even though it will be F company) o Determination of Earnings, Foreign Taxes and Dividend for Calculating the Indirect Credit  Reasons for Adoption of Perpetual Pools  It was too easy for TP to distribute up high tax earnings  created more deemed paid taxes o Before pools it was calculated on just year to year basis  Common scheme before pools: o US parent with two F subs – one in low tax and one in high tax o In odd years it would distribute from high tax sub and in even years from low tax sub  This strategy no longer works with the pools  US Rules Used in Calculating Earnings in the 902 Denominator  United States vs. Goodyear o Issue: whether the effect of a F corp’s losses on its earnings should be determined under US or F rules for determining the indirect credit o It is under the old formula where the amount deemed paid = F Taxes x (Dividend / Accum Profits – Taxes) o Domestic and F law are giving different amounts for Accum Profits o TP was concerned with a double tax problem – but the issue no longer exists with pooling  Vulcan v. CIR o Issue: whether the term “accumulated profits” includes portion of Saudi Arabian corp’s profits not taxed o Court holds that Vulcan’s interpretation of “accumulated profits” is correct – that it doesn’t include the Saudi corp’s untaxed profits Foreign Tax Credit Limitations o After TP identifies taxes that qualify under direct (901) or indirect (902), the taxes are totaled  Amount that can actually be claimed as credit is subject to Sec 904  F taxes in excess of limitation can be carried back and carried over o Purpose of Limitations  If no limitation, F taxes paid at rates higher than US rates would reduce US taxes on US source income  904(a) – Overall Limitation  (F Source TI / WW TI) x US tax on WW income (before FTC)  Reduces to: US Tax rate x F Source Taxable Income  TPs Goal: to increase amount of F Source income that is subject to low tax  increases limitation

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o This leads to a blending or cross-crediting of the tax rate applicable to high tax and low tax o Adding in the low tax F income  increases the limitation without any increase in F taxes  904(d) – Separate Limitation  Requires that the 904(a) limitation be applied separately to different categories of income  Before 2007: 8 total categories  After 2007: only 2 categories: passive and general  Excess Limitation: US TP has greater amount of limitation in particular basket than is potentially creditable  Excess Credit: US TP has creditable in amount greater than the applicable limitation  May be carried back to prior year or carried forward ten years o Policy Arguments For and Against the Overall Limitation  Against: Cross-crediting raises a number of concerns:  (1) Encourages TPs with operations in high tax F country to invest in low tax F country, rather than US  (2) Permits some F countries to maintain high tax rates without losing US investment  For: Ability to Average should not be limited  (1) Limitations on averaging harm the ability of US TPs to compete with F TPs that use territorial systems that give exemption for F source income  (2) Non-tax considerations dominate decisions where to invest  (3) Increases complexity o Separate Basket Limitations  Three possible ways to carve up F source income: per item limitation, per country limitation, per category limitation  Per Item Limitation: Administratively impossible  Per Country Limitation:  US has used per country limitation in the past – it sub-divides F source income by country  Criticism: Assume $100 income in France and $100 loss in Bermuda  FTC credit of $35  odd b/c total FSI = 0  no credit  Per Category Limitation: this is what we have – JOBS Act reduced from 8 baskets to 2 baskets  904(d) requires that you calculate the 904(a) credit separately for each basket that TP has income  Current Law: Two baskets o 904(d)(1)(B) Passive basket – generally aligns with subpart F income  If it’s taxed at rate higher than US rate  general basket o 904(d)(1)(A) General basket o The 10-50 Baskets 35

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Assume a US Co holding greater than 10%, but less than 50% of F co Different rules for pre-2002 and post-2002 Pre-2002: 10-50 Separate Basket  Dividend is paid up to US parent and all gets put into one “10-50” basket  All dividends from all 10-50 F Co’s go into the 10-50 basket  Post-2002: Look-Through Rule  When a dividend is paid up to US parent, the correct basket is determined by “looking through” and seeing what is happening in the active business below o Source and Tax Planning  Before baskets, TP generally tried to plan by moving income from US to F  After baskets, essentially same dynamic, except TP tries to move F income from a low tax basket to a high tax basket o Compaq Computer Corp v. CIR  Compaq buys $888M shares of Royal Dutch. Compaq incurs transaction cost of $2M. Royal Dutch pays a 23M dividend (3M WH tax)  Compaq receives $20M. Compaq sells the shares of $868M.  TP essentially paid a bank $2M for no gain - the reason is its all about taxes  Potential Benefits: $20M capital loss, $3M FTC, $2M transaction cost  Case is about analysis of economic substance  Govt’s Theroy:  Pre-tax: $2M loss  After-tax: Assume 30% rate – sums all the benefits up to $2.7M loss  700k better off than not doing the transaction  lacks economic substance  TP’s Theory:  Pre-tax: Since it’s pre-tax, must consider the full 23M dividend o Subtract 20M capital loss and 2M transaction cost  1M profit  After tax: 1M x 30% = 300k tax  700k better off  Both come out to same number, it’s just about whether a profit existed before tax  Court holds for TP because you can’t just ignore the $3M since it rests on a pre-tax argument  Alternative Reasoning to hold for Gov’t  Concede that dividend is $23M and proceed on theory of trafficking of tax attributes  Statutory Response – 901(k): TP may not claim a credit on a WH tax unless holding shares for 30 days (now there would actually be risk involved) Overall Foreign Losses – 904(f) o Foreign losses would offset US income tax liability (WW system) o However, if such is too generous, then 904(f) addresses with a recapture provision o Example: Assume US rate = 35%, F rate = 40%  Year 1: F loss of (1000), US income of $2000  Total US tax of $350, no F tax  Year 2: F income of $1000, US income of $2000 36

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US tax of $1050, F tax of $400 Without 904(f)  FTC of $350 o Seems wrong because aggregate income over 2 years = 0 Year 3: F income of $1000, US income of $2000  US tax of $1050, F tax of $400  904(f) recaptures the $1000 F loss that we let offset the US income in Year 1 o 50% of F source income is recharacterized as USI  So in both Y2 and Y3, there is actually $500 F source income and $2500 USI o This makes the FTC limitation = 175 for both years

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Anti-Deferral Regimes (Particularly Subpart F)  Introduction and Overview o Concept of Deferral:  US Person who conducts a business or invests abroad is taxed by US on the F source income (subject to FTC)  By contrast, a US person that does same through a F corp generally pays no tax until earnings are repatriated  When tax if F country is lower than US rate, deferral of US taxes  reduces effective tax rate  If not limited, the deferral principle violates CEN and gives incentive for US TPs to move operations abroad to low tax jurisdictions o Congress created anti-deferral regimes to combat deferral  Prevents the channeling of passive income into a F corp (“incorporated pocketbook”) in a tax haven  Main approach: impose constructive dividend treatment on US persons owning such F entities  The regimes are only aimed at passive income – deferral for active income is okay o Three key elements of anti-deferral regimes:  (1) Definitional / Trigger Conditions  It applies to F corps, but should it apply to all F corps  Should only SHs who have ability to compel distribution lose deferral?  (2) Base (Active / Passive)  Once trigger is met, should deferral be eliminated for all income  Which income loses deferral?  (3) Mechanic of Inclusion – the possibilities are: constructive dividend, interest charge, mark to market approach o JOBS Act repealed FPHC provisions and only left three regimes: CFC, PFIC, and accumulated earnings tax (rarely applies to F corp) Controlled Foreign Corporation Provisions (Subpart F) o Introduction  Definitional / Trigger: 951(a),(b); 957(a),(c); 958(a),(b)  Base Determinations: 954, 956 37

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 Mechanics: 951(a)(2), 959, 960 o Definitional / Trigger  957 - CFC = a F corp if more than 50% of the corp is owned by US Shareholder on any day during the taxable year  “US Shareholder” = a 10% or more shareholder  Easy enough but the complication is figuring out what a person owns constructively and indirectly, in addition to direct  The rules piggyback on 318  Indirect and Constructive Ownership  958(a) – Indirect – involves cases where person is the actual beneficial owner o Rule of Proportionality  958(b) – Constructive – involves cases where ownership is “made-up” – treat H as owning shares b/c W owns them o Four Categories: Family, “From” entity, “Two” entity, Options o Family Attribution: same rules as 318, but US person cannot be deemed to hold shares held by F person o “From” Entity Attribution  P-ships: An individual that holds any % of a p-ship will be deemed to own same % of the p-ships shares  If holds greater than 50%  deemed to own all the shares held by p-ship  Corps: An individual must hold 10% of a corp and then will be deemed to own proportionate amount.  If individual holds greater than 50%  deemed to own all the shares held by corp  Attribution from an entity can occur multiple times, but will not apply w/r/t/ stock that was attributed “to” the entity under the rules below o “To” Entity Attribution  All stock owned by a partner in a p-ship is attributed to the p-ship  All stock owned by a SH of a corp is attributed to such corp, but only if the SH owns 50% or more of the corp  Attribution to entities can occur multiple times  Shares held by F person generally not attributed to US person o Options: Holder of an option on stock is treated as the owner of the underlying stock  Once US SHs are identified, then the corp is a CFC if held 50% or more by US SHs on any day during the taxable year  30 Day Requirement: In order for US SHs to be subject to current inclusion, the F corp must have been a CFC for an uninterrupted person of at least 30 days

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Last Day of the Year Requirement: Only US SHs who hold stock of CFC on last day of taxable year are subject to current inclusion o Mechanics of Inclusion  Idea is to end deferral with a constructive dividend under 951(a)(1)  Amount of inclusion = pro-rata inclusion of SpF income under 958(a)(2) and EP Calculation under 952(c)  Pro-rata Amount – 958(a)(2) – must account for three things:  (1) Percentage of Ownership o This includes amount owned directly and indirectly, but not constructively  (2) Percentage of Year that Corp is CFC o If corp is only CFC for 50% of year, then only 50% of SpF income gets included among all US SHs  (3) Mid-Year Dividends o If distribution was made to another US SH prior to acquisition by current US SH, the amount of inclusion will be adjusted downward by the proportion of time not owned  EP Limits – 952(c)  Maximum amount of constructive dividend is capped at current EP  Ex: CFC has $200 loss from non-SpF income and $100 of SpF income  overall loss  cannot give rise to a constructive dividend  Foreign Tax Credit – 960  960 piggybacks on 902  With the indirect credit, a corp had to hold 10% to be entitled to the credit when a dividend was distributed  Now, by definition of CFC, the SH will own 10% when the constructive dividend is made o Again, the credit under 960 is only available to Corp SH, not individual  Elimination of Double Tax: 959 and 961  When there is a constructive dividend, the money is still in the CFC and it does not reduce EP  Sec 959 and 961 prevent the US SH from getting hit with tax again when there is an actual distribution (959) or if the SH sells and the price paid reflects the current EP (961)  959 – Previously Taxed Income o Assume US Co holds CFC. In Year 1, $50 of SpF income. IN Year 2, $50 of non-SpF income. $100 distribution in Year 2.  Under CFC rules, there was $50 constructive dividend in Year 1. Therefore, in Year 2 only $50 is included in gross income o Instead, in Year 2, assume $50 distribution.  Still had $50 inclusion in Y1  No inclusion is year 2 o Rule: actual distribution is treated as being distributed out of SpF income first 39

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961 – Basis Rule o Constructive dividend  basis increase o Actual distribution  basis decrease o Subpart F Income  Three pieces: F Base Company Income (954(c)); Sales Income (954(d)); Service Income (954(e))  The offending items will be passive income mostly  Foreign Base Company Income  Includes most types of passive income: Interest, Dividends, Rents, Royalties, and Gains form Sale of Property producing such income  Exceptions o 954(c)(2)(A) – Active Rents and Royalties  If they are active, then they will not be SpF income  Active = self created intangibles, purchase and add value, or purchase and do substantial marketing o 954(c)(3) – Related Party Exception  Ex: CFC1 holds CFC2 in same country and 2 pays a dividend to 1  not SpF income  Foreign Base Company Sales Income  Assume a business that has manufacturing and sales. Mfger is relatively fixed, but TP may try to channel sales through a “base company” in a low tax J. o Assume US TP would sell a product for $100 (inclusive of mfger and sales component) o If TP can sell it for $60 to a base company and then to buyer for $100  $40 of profit shifted into low tax F base company  954(d) – attacks the above structure o Statute is confusing, but addresses two things: relatedness and geography (no worries if happening in same country) o Relatedness – two paradigm transactions:  Principal (Purchase / Sale transaction)  CFC in the middle of the seller and the purchaser  If there is a related party to the CFC on either side of the transaction  SpF income  Agent  Goods go directly from Seller to Buyer and the CFC is acting as either seller’s agent or buyer’s agent  When CFC is related to it’s principal, the commission paid  SpF income o Geography  Purchase / Sale: both parties on each side of CFC must be out of the CFC’s jurisdiction  Agent: The principal must be outside of the CFC’s jurisdiction 40

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Manufacturing Exception o If the CFC is also manufacturing, there the F base sales income will not be SpF income o Two ways to take advantage of the manufacturing excepton:  (1) Same Country: move the manufacturing into the J of the CFC (even if not CFC doing it)  (2) Same Company: have the CFC manufacture the goods itself (even if outside the J of the CFD) o 954(d)(1): Purchase of Property and its Sale  Purchasing property and selling same =/= mfgering  Purchase property and make other stuff = mfger (if CFC is having substantial activities or substantial transformation) o There is an underspecification of the law and it’s very advantageous if CFC can get within the exception  Foreign Base Company Service Income – 954(e)  Assume US Co with Sub in High Tax J does selling and provides high value services  service income is subject to high tax o TP sets up CFC and moves the services there o Now High Tax Sub gets deduction and income shifted to CFC  Same Factors for Sale will determine if income is SpF income: o Relatedness: if CFC provides the services for a related party or on behalf of related party o Geography: if services are performed outside of J of CFC  Miscellaneous Rules  De Minimis: If CFC’s base income is less than 1,000,000 or 5% of its inocme, it will be ignored  Full Inclusion: If CFC’s F base income is greater than 70% of all its income  all income = SpF income  High Tax Rule: if a F corp is caught by all CFC rules, but actually pays tax close to US rate  no current inclusion o Earnings Invested in US Property – Sec 956  Under 951(a)(1), the current inclusion =  (A) the pro-rata share of SpF income (everything above), and  (B) amount determined under 956 o 956 is not really SpF income, but subject to the same inclusion  Assume US Co holds CFC which has 100% non-SpF income  In order to get the money back to US Co and still getting deferral, the CFC loans the money to the US parent  This is effective use of the proceeds so tax should be paid  Definition of “Investments in US Property” – 956(c)  “US Property” includes: (1) Tangible property located in the US; (2) Stock of a US corp; (3) Obligations of US persons; (4) any right to use patents, know-how, copyrights, etc. in US o Gains from Certain Sales or Exchange of Stock in CFCs – Sec 1248

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Assume a US SH holds a CFC and navigates all the rules and succeeds in getting deferral  We don’t want to let the SH then sell the shares and convert it to capital gain  1248 will convert a portion of the gain to ordinary income  This is actually favorable for corps because the conversion carries with it a foreign tax credit Passive Foreign Investment Company Provisions – PFIC o Introduction  The PFIC regime attempts to end deferral in certain circumstances when the US SH has a relatively smaller stake  It doesn’t follow constructive dividend scheme of CFC b/c SH cannot force a distribution  Instead it uses (1) mark to market, (2) interest charge when PFIC makes distribution, or (3) if PFIC is Qualified Election Fund, the SH can include a pro-rata amount (requires company to provide such information) o Definition of PFIC (sort of the opposite of FIRPTA)  A F corp is a PFIC if at least 75% of its GI is passive income (income test) or the percentage of its assets producing passive income is 50% (asset test)

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