U.S. Federal Income Tax Compliance Issues In Foreign-Related Transactions

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1 U.S. Federal Income Tax Compliance Issues In Foreign-Related Transactions December 6, 2012 University of Texas School of Law 60 th Annual Taxation Conference AT&T Conference Center Austin, Texas WILLIAM H. HORNBERGER JACKSON WALKER L.L.P. 901 MAIN STREET, SUITE 6000 DALLAS, TEXAS William H. Hornberger IRS Circular 230 Notice: The statements contained herein are not intended to and do not constitute an opinion as to any tax or other matter. They are not intended or written to be used, and may not be relied upon, by you or any other person for the purpose of avoiding penalties that may be imposed under any Federal tax law or otherwise. - i -

2 TABLE OF CONTENTS Page I. INTRODUCTION...1 A. Foreign Persons Doing Business or Investing in the U.S....1 B. U.S. Taxation of U.S. Citizens and Residents and U.S. Corporations...2 II. SOURCES OF INCOME...3 A. Statutory Framework...3 B. Sources of Specific Types of Income Interest...4 a. U.S.-Source Interest...4 b. Foreign-Source Interest Dividends....5 a. U.S.-Source Dividends...5 (1) General Rule....5 (2) Qualifying Foreign Corporation....5 b. Foreign-Source Dividends Personal Service Income....5 a. U.S.-Source Income...5 b. Foreign-Source Income...6 c. Services Performed Partly Within and Partly Without the U.S Rents and Royalties...7 a. U.S.-Source Income...7 b. Foreign-Source Income Real Estate Sales....8 a. U.S.-Source Income...8 b. Foreign-Source Income Sales of Non-Inventory Property....8 a. U.S.-Source Income...8 b. Foreign-Source Income Sales of Inventory ii -

3 a. Title-Passage Rule...9 (1) U.S.-Source Income (2) Foreign-Source Income (a) General Rule (b) Exception for Nonresidents b. Comments Concerning Passage of Title...10 c. Source Rules for Inventory Produced in One Jurisdiction and Sold in Another Jurisdiction Guarantee Income...12 a. U.S.-Source Income...12 (1) New Section 861(a)(9)(A) (2) New Section 861(a)(9)(B) b. Foreign-Source Income...13 III. U.S. TRADE OR BUSINESS STATUS OF FOREIGN PERSONS IN THE UNITED STATES...14 A. What Is the Significance of a Nonresident Alien or Foreign Corporation Engaging in a U.S. Trade or Business?...14 B. How Is Trade or Business Status Determined? Relevant Factors in Determining Trade or Business Status Activities of Agent Attributed to Nonresident Alien or Foreign Corporation Trade or Business Includes Performance of Personal Services in the U.S Special Rules Apply to Trading in Stocks or Securities...15 IV. EFFECTIVELY CONNECTED INCOME...16 A. The Significance of Effectively Connected Income...16 B. Rules Governing the Determination of Whether Income is Effectively Connected U.S.-Source Income...16 a. U.S.-Source Capital Gain or Loss and U.S.-Source Income Subject to Gross-Basis Taxation...16 (1) Asset-Use Test (2) Business-Activities Test iii -

4 b. All Other U.S.-Source Income Foreign-Source Income Treatment of Deferred Payments Special Treatment of Certain Property Transactions...18 V. CLASSIFICATION OF INDIVIDUALS AND ENTITIES FOR U.S. FEDERAL INCOME TAX PURPOSES...20 A. Definition of Nonresident Alien for U.S. Federal Income Tax Purposes Nonresident Alien is an Individual Who is Neither a U.S. Citizen Nor a U.S. Resident...20 a. Determining Residency of an Individual for U.S...20 b. The Green Card Test...20 c. The Substantial Presence Test (1) General Rule (2) Closer Connection Exception to Substantial Presence Test (3) Other Exceptions to Substantial Presence Test Treaties...21 B. Classification of Entities for Federal Income Tax Purposes Background Final Check-The-Box Regulations Step One: Determine Whether a Separate Entity Exists for Federal Tax Purposes...22 (1) Federal Tax Law Controls Whether Entity Is Separate from Owners Certain Joint Undertakings May Constitute Separate Entities for Tax Purposes (3) Certain Single-Owner Organizations Can Choose Whether to be Recognized Step Two: If a Separate Entity Exists, Determine Whether the Entity Is a Trust or a Business Entity Step Three: If an Entity Is a Business Entity, Determine Whether It Is Automatically Classified as a Corporation Step Four: If an Entity Is a Business Entity and Is Not Automatically Classified as a Corporation, Classify the Entity According to the Regulations...26 (1) General Classification Rules iv -

5 (2) Default Classification Rules (For Eligible Entities That Do Not File an Election) (a) Domestic Eligible Entities (b) Foreign Eligible Entities (3) Procedural Rules for Filing Election Elective Changes in Classification Revenue Ruling Administrative Dissolution...29 C. Foreign Corporation...30 D. Foreign Trust...30 E Expatriation Legislation General Operation of Section 877A and Section Property Subject to the Deemed Sale Rules of Section 877A Application of Section 877A...31 VI. U.S. FEDERAL INCOME TAXATION OF U.S. TRADE OR BUSINESS INCOME OF FOREIGN PERSONS...32 A. General Pattern of Taxation of U.S. Trade or Business Income of Foreign Persons...32 B. Taxation of U.S. Capital Gain Income...32 C. Branch Profits Tax Applies to Foreign Corporations Doing Business in the U.S...33 D. Special Withholding Rules Applicable to Partnership Effectively Connected Income Withholding on Partnership Effectively Connected Taxable Income Determining Effectively-Connected Taxable Income Service Issues Regulations Addressing Withholding Rules Applicable to Partnership Effectively Connected Income...33 E. Income Tax Treaties May Modify the General Rules of Taxation...33 F. Selected U.S. Reporting Issues U.S. Federal Income Tax Return a. Nonresident Alien...33 b. Foreign Corporation...34 c. Failure to Timely File Return Results in Loss of Deductions v -

6 2. Internal Revenue Service - Section 6038A (Related Party Transactions - Form 5472) Agricultural Foreign Investment Disclosure Act of International Investment Survey Act of International Transportation of Currency or Monetary Instruments Foreign bank accounts...37 a. Statutory and Regulatory Background...38 b. Question Regarding Foreign Bank Accounts in Part III of Schedule B of IRS Form c. Treasury Issues Final FBAR Regulations and Form TD F (Rev...39 (1) General Filing Requirements (2) Statutory and Regulatory Elements (a) United States Person (b) Bank, Securities or Other Financial Account in a Foreign Country (c) Types of Reportable Accounts (d) Exceptions for certain accounts (e) Financial interest (f) Federal Tax Treatment Does Not Control Filing Requirement (g) Signature or Other Authority (h) Special Rule for Certain Trust Beneficiaries (i) Special Rule for U.S. Persons with a Financial Interest in, or Signature or Other Authority Over, 25 or More Foreign Financial Accounts (3) Anti-Avoidance Rule Reporting Specified Foreign Financial Assets on Form a. Enacting Legislation; Effective Date...46 b. Requirement to Report Specified Foreign Financial Assets...46 (1) General Rule (2) No Form 8938 Filing Requirement if Specified Individual Is Not Required to File a Return c. Statutory and Regulatory Elements...46 (1) Specified Person (a) Specified Individual (b) Specified Domestic Entity vi -

7 (2) Determining the Reporting Threshold (a) Unmarried Specified Individual Living in the U.S (b) Married Specified Individuals Living in the U.S. and Filing a Joint Return (c) Married Specified Individuals Living in the U.S. and Filing Separate Returns (d) Special Rule for Specified Individuals Living Abroad (e) Jointly-Owned Assets (f) Special Valuation Rule for Interest in a Foreign Trust (g) Special Valuation Rule for Interests in Foreign Estates, Pension Plans, and Deferred Compensation Plans (3) Specified Foreign Financial Assets (a) Financial Accounts Maintained by a Foreign Financial Institution (b) Other Specified Foreign Financial Assets (4) Interest in a Specified Foreign Financial Asset (a) General Rule (b) Special Rule For Parents Making Election Under Code Section 1(g)(7) (c) Treatment of Specified Financial Assets Held by Entities...54 (d) Special Rule for Foreign Estates and Foreign Trusts...55 d. Reporting on Form (1) Required Information (2) Reporting Period (a) Reporting Period for a Specified Individual (b) Reporting Period for a Specified Domestic Entity (3) Treatment of Married Individuals (a) Married Specified Individuals Filing a Joint Return - Single Form (b) Married Individuals Filing Separately (c) Example vii -

8 (4) Treatment of Certain Assets Excepted from Reporting on Form (a) Treatment of Certain Assets Reported on Other Forms (b) Treatment of Certain Grantor Trusts e. Valuation of Assets...59 (1) Fair Market Value Standard (a) Maximum Value (b) U.S. Dollars (c) Assets With No Positive Value (d) Foreign Currency Conversion (2) Valuing Financial Accounts (3) Valuing Other Specified Foreign Financial Assets (a) General Rule (b) Special Valuation Rules for Interests in Foreign Trusts (4) Special Valuation Rule for Interests in Foreign Estates, Pension Plans, and Deferred Compensation Plans (5) Special Rules for Jointly owned Interests f. Penalties for Failure to Disclose...61 (1) General Rule (2) Married Individuals Filing a Joint Annual Return (3) Presumption of Aggregate Value (4) Reasonable Cause Exception g. Coordination with Form TD F VII. THE BRANCH PROFITS TAX...63 A. Application and Tax Rate Items of Income Excluded from Branch Tax Computation of Effectively-Connected Earnings and Profits Adjustments to Reflect Changes in U.S. Net Equity...63 B. Branch-Level Interest Tax...63 C. Anti-Treaty Shopping Provision Under Branch Profits Tax...64 D. Exception for Termination of U.S. Branch viii -

9 VIII. U.S. INCOME TAXATION OF U.S. SOURCE FIXED DETERMINABLE ANNUAL OR PERIODICAL INCOME...65 A. General Patterns of Taxation of Fixed Determinable, Annual or Periodical Income Effectively Connected Fixed Determinable, Annual or Periodical Income Non-Effectively Connected FDAP Income...65 B. Special Issues Relating to Non-Effectively Connected FDAP Income Treatment of Original Issue Discount...65 a. Treatment of Domestic Holders of OID Instruments...66 b. Payments on Original Issue Discount Obligation...66 c. Payments Received from Sale or Exchange of Original Issue Discount Obligations...66 d. Exclusions from Definition of Original Issue Discount Obligation (1) Short-Term Obligations (2) Tax-Exempt Obligations Special Treatment of Interest on Deposits Exception for Portfolio Interest a. Treatment of Portfolio Interest...67 b. Definition of Portfolio Interest. The term portfolio interest means non-exempt U.S...67 (1) Bearer Obligation Test (2) Registered Obligation Test c. Exceptions and Special Rules Special Rule for Dividends from 80/20 Corporations...69 C. Other Items of Income Subject to 30% Flat Tax Certain Timber and Iron Ore Gains Gains from Sale or Exchange of Certain Intangible Property...69 D. Withholding of Tax on FDAP Income of Nonresident Aliens and Foreign Corporations Withholding Agents Required to Withhold 30% Tax ix -

10 a. Withholding Obligation Applies to Payment of FDAP Income in Series of Repeated Payments or in a Single Lump Sum...69 (1) Description of Fixed or Determinable Annual or Periodical Income (2) Sales Income Is Not FDAP Treatment of Domestic Partnerships with Nonresident Aliens and Foreign Corporations as Partners a. Withholding on Payments to Domestic Partnership with Foreign Partners...70 b. Withholding by U.S Treatment of Foreign Partnerships Corporate Distributions a. Dividend Distributions...71 b. Other Distributions Exceptions and Exemptions from Withholding; Special Rules a. Foreign Source Income...72 b. Income Effectively Connected with the Conduct of a U.S...72 c. Treatment of Compensation for Services (1) Services Performed by a Foreign Partnership or a Foreign Corporation (2) Services Performed by an Individual Liability for Withholding Tax Reporting Requirements a. Form b. Form 1042S Withholding Tax as Credit to Recipient of Income...73 E. Obtaining Reduced Treaty Withholding Rates...73 F. Reporting of Bank Deposit Interest...73 G. Expansion of Information Reporting Requirements on Foreign Financial Institutions March 18, 2010: HIRE Act Adds New Chapter February 8, 2012: U.S. Treasury Department and IRS Publish Proposed Regulations Under Chapter x -

11 3. February 8, 2012: Treasury Announces Intergovernmental Framework for FATCA Implementation May 15, 2012: IRS Holds Public Hearing on Proposed Regulations July 26, 2012: U.S. Treasury Department Releases First Model For Bilateral Agreements with Other Jurisdictions September 14, 2012: U.S./U.K. Announce Signing of Bilateral Agreement for Implementation of FATCA October 24, 2012: IRS Announces Modification of Certain FATCA Timelines November 8, 2012: Treasury Announces Cooperation with Other Countries to Implement FATCA November 14, 2012: Treasury Releases a Second Model Intergovernmental Agreement for Implementation of FATCA November 15, 2012: U.S. and Denmark Sign FATCA Agreement November 19, 2012: U.S. and Mexico Sign FATCA Agreement...78 IX. SPECIAL TAX CONSIDERATIONS PERTAINING TO OWNERSHIP AND DISPOSITION OF U.S. REAL ESTATE BY FOREIGN PERSONS...79 A. Background and General Pattern of Taxation Background General Pattern of Taxation...79 B. Election to Treat All Income from U.S. Real Estate as U.S. Trade or Business Income...79 C. Treatment of Dispositions of U.S. Real Property Interests by Foreign Persons Definition of U.S. Real Property Interest a. Definition of Real Property and Interest in Real Property b. Definition of U.S...81 c. Treatment of Interests in Partnerships Owning U.S Application of Nonrecognition Provisions Section 897(i) Election...82 D. Withholding on Disposition of U.S. Real Property Interests General Withholding Requirement Reporting and Payment Requirement Liability of Transferee...83 E. Exemptions and Special Rules xi -

12 1. Purchase of Residence for $300,000 or Less Notice of Nonrecognition Stock Regularly Traded on Established Securities Market Non-USRPHC Affidavit Nonforeign Affidavit Options, Installment Sales and Foreclosures Withholding Certificates...84 F. Withholding Rules for Corporations, Partnerships, Trusts or Estates...84 G. Service Issues Final Regulations Requiring Foreign Transferors to Provide Taxpayer Identification Numbers...84 X. SELECTED U.S. PAYROLL TAX ISSUES RELATING TO NONRESIDENT ALIENS...85 A. FICA General Statutory Authority for FICA Tax Liability Imposition of FICA Taxes on Wages Paid by U.S. and Foreign Persons a. Wages Paid by U.S...86 b. Wages Paid by Foreign Person/Employer Exception to Liability for Persons in Certain Visa Categories Impact of Totalization Agreements...86 B. FUTA General Statutory Authority for FUTA Tax Liability Imposition of FICA Taxes on Wages Paid by U.S. and Foreign Persons a. Wages Paid by U.S...87 b. Wages Paid by Foreign Person/Employer Exceptions to Liability for Persons in Certain Visa Categories...87 C. Self-Employment Tax...87 XI. TAX TREATIES...88 A. Functions of Tax Treaties...88 B. Persons Covered...88 C. Issues Covered...88 D. Other Matters Often Covered in Income Tax Treaties...88 E. Disclosure Requirement...89 F. Relationship of Treaties to Internal U.S. Law xii -

13 1. How are Treaties Adopted? In the U.S., the procedure involved in adopting a treaty is different from that involved in passing a Federal statute U.S. Constitution Provisions of Internal Revenue Code Affecting Interrelationship between Treaties and Internal U.S. Law...90 G. Authority of the Commissioner to Recharacterize Transactions Involving Treaty Shopping I.R.C. 7701(l) Judicial Doctrines Limitation of Benefits Provisions in Income Tax Treaties...92 XII. U.S. ESTATE AND GIFT TAX CONSIDERATIONS FOR NONRESIDENT ALIENS...94 A. General Rule Applicable to Nonresident Aliens for Purposes of U.S. Federal Estate and Gift Taxation...94 B. Residency for U.S. Estate and Gift Tax Purposes...94 C. Overview of U.S. Estate Tax Rules Applicable to Nonresident Aliens Determining the Gross Estate...94 a. Property Situated in the U.S...94 b. Property Not Situated in the U.S Estate Tax Rates Estate Tax Credit...95 D. Overview of U.S. Gift Tax Rules Applicable to Nonresident Aliens...96 E. U.S. Estate and Gift Tax Treaties...96 XIII. THIN CAPITALIZATION ISSUES...97 A. Advances Between Related Companies Are Closely Scrutinized...97 B. Judicial Analysis of Debt-Equity Cases...97 C. Laidlaw Transportation, Inc. v. Commissioner D. Nestle Holdings, Inc. v. Commissioner E. Plantation Patterns Doctrine What is the Plantation Patterns Doctrine? When Do The Courts Generally Apply the Plantation Patterns Doctrine? XIV. LIMITATION ON EARNINGS STRIPPING A. Background xiii -

14 1. Section 163(j) Enacted in Issuance of Proposed Regulations in Amendment to Section 163(j) in Amendment to Section 163(j) in B. General Operation of Section 163(j) Debt-to-Equity Ratio Exceeds 1.5 to a. Definition of Total Debt b. Definition of Equity Company Pays or Accrues Disqualified Interest During Tax Year a. Definition of Disqualified Interest b. Definition of Related Person Net Interest Expense of Company Exceeds 50% of Adjusted Taxable Income Plus Excess Interest Limitation Carryforward a. Definition of Net Interest Expense. The net interest expense of the company is the excess of interest paid or accrued by the company for the tax year, over interest income of the company for the tax year b. Definition of Adjusted Taxable Income c. Excess Interest Limitation Carryforward d. All Members of Affiliated Group Are Treated as One Taxpayer If Section 163(j) Applies to a Corporation, What Are the Consequences? C. Examples Example a. Consequences in b. Consequences in c. Consequences in Example XV. SECTION 267(a)(3) XVI. ANTI-DEFERRAL MECHANISMS APPLICABLE TO U.S. INVESTORS IN FOREIGN CORPORATIONS xiv -

15 A. Controlled Foreign Corporations Statutory Pattern of Taxation Classification as a Controlled Foreign Corporation Subpart F Income a. Subpart F Income Includes Five Categories of Income b. Income Excludable from Subpart F income c. Subpart F Income Limited to Current Earnings and Profits of a CFC d. Description of Foreign Base Company Income (1) Exclusions and Special Rules Applicable in Computing Foreign Base Company Income (a) De Minimis Rule (b) Full Inclusion Rule (c) Exception for Income Subject to High Foreign Taxes (d) Deductions to be Taken into Account (2) Foreign Personal Holding Company Income (3) Foreign Base Company Sales Income (a) The Related-Party Element (b) The Manufacturing Element (c) The Use Element (4) Certain Branch Income e. Foreign Base Company Services Income (1) General Definition (a) Related-Party Element (b) Foreign Country Element (2) Certain Income Not Included f. Foreign Base Company Oil-Related Income (1) Items Included Within Foreign Base Company Oil- Related Income (2) Income Excluded from Foreign Base Company Oil- Related Income (3) Exemption for Small Oil Producers Increase in Earnings Invested in U.S. Property xv -

16 B. Passive Foreign Investment Company Classification as a PFIC a. Passive Income Test b. Passive Asset Test Consequences of PFIC Classification a. Treatment of Excess Distributions from PFIC (1) Computation of Tax on an Excess Distribution (2) What Is an Excess Distribution? b. Treatment of Dispositions Qualified Electing Funds C. Other Statutory Mechanisms Imposed to Curtail Deferral of Income Accumulated Earnings Tax Rules D. Coordination of Anti-Deferral Mechanisms XVII. THE DIRECT FOREIGN TAX CREDIT A. Tax Treatment of Foreign Taxes In General B. Analysis of Six Issues Is the Taxpayer Eligible to Claim the Foreign Tax Credit? Is the Tax a Creditable Tax? a. Predominant Character of Tax Must be that of an Income Tax in the U.S b. Tax in Lieu of an Income Tax Who Is the Taxpayer that Should Claim the Foreign Tax Credit? Do Any Special Limitations Apply that May Reduce the Amount of the Credit? Does the Overall Limitation on the Foreign Tax Credit under Section 904 Limit the Amount of the Creditable Taxes? a. Computation of Limitation b. Application of Limitation Formula c. Treatment of Separate Basket Losses d. Recapture of Overall Foreign Loss e. Carryback and Carryover of Excess Taxes Paid xvi -

17 6. What Is the Time and Manner for Claiming the Foreign Tax Credit? a. Time b. Manner XVIII. INDIRECT FOREIGN TAX CREDIT XIX. SECTION 367(a) - TRANSFER OF ASSETS TO A FOREIGN CORPORATION XX. INTERNATIONAL TRANSFER PRICING OF GOODS AND SERVICES A. The Statute B. Purpose of Section C. Use of Section 482 by the IRS and Taxpayers Use of Section 482 by the IRS a. Intent to avoid or evade taxes not a prerequisite b. Section 482 also applies to consolidated groups Taxpayer s use of Section D. Arm s length standard General rule Selection of method for testing whether a transaction meets the arm s length standard; best method rule XXI. Section 1059a APPENDIX - FORMS - xvii -

18 I. INTRODUCTION A. Foreign Persons Doing Business or Investing in the U.S.. Foreign persons who plan to do business in the United States or invest in a new or existing U.S. business entity are faced with a myriad of business, legal and tax issues. U.S. counsel advising foreign persons regarding the ownership structure for a contemplated business or investment in the United States should have a basic understanding of the U.S. system of international taxation of foreign persons. Nonresident aliens and foreign corporations are subject to U.S. federal income taxation on their taxable income that is effectively connected with the conduct of a U.S. trade or business. The U.S. also imposes a 30% tax (or such lesser rate as is provided by an applicable income tax treaty) on the gross amount of U.S. source interest, dividends, rents, royalties and other fixed, determinable, annual or periodical income from U.S. sources of nonresident aliens and foreign corporations if such income is not effectively connected with the conduct of a U.S. trade or business. In addition, foreign corporations doing business in the U.S. are subject to the branch profits tax. U.S. income tax treaties often modify the general rules of taxation for nonresident aliens and foreign corporations doing business or investing in the U.S. An applicable income tax treaty may reduce or eliminate the 30% gross-basis tax imposed on nonresident aliens and foreign corporations. In addition, an applicable income tax treaty may limit the imposition of U.S. tax on business operations of a foreign person to cases where the business is conducted through a permanent establishment. For U.S. federal estate and gift tax purposes, nonresident aliens are subject to U.S. federal estate and gift tax on their property situated in the U.S. U.S. estate tax treaties may affect the determination of whether an alien is domiciled in the U.S. for U.S. estate tax purposes. The general pattern of U.S. international taxation of foreign persons gives rise to a host of issues that a U.S. advisor should consider when developing the structure for a business or investment in the U.S., including: 1. How is income sourced for U.S. federal income tax purposes? business? 2. Will the foreign person be engaged in the conduct of a U.S. trade or 3. Will income generated by the foreign person be treated as effectively connected with a trade or business conducted by such foreign person? 4. If a foreign person does business or invests in the U.S. through a U.S. or foreign entity, how will the entity be treated for U.S. federal income tax purposes? 5. If a foreign person s taxable income is effectively connected with the conduct of a U.S. trade or business, what is the method and rate of U.S. federal income taxation of such income? - 1 -

19 6. What is the branch profits tax and how does it apply to foreign corporations doing business in the U.S.? 7. What is the method and rate of U.S. federal income taxation on a foreign person s U.S. source fixed or determinable annual periodical income? 8. What special U.S. federal income tax considerations apply to foreign persons owning or disposing of a U.S. real property interest? 9. What is the function of income tax treaties and how do they modify the general U.S. rules of federal income taxation? 10. What special U.S. federal estate and gift tax considerations apply to foreign persons doing business or investing in the U.S. corporations? 11. What special financing considerations apply to foreign-owned U.S. B. U.S. Taxation of U.S. Citizens and Residents and U.S. Corporations. U.S. citizens, resident aliens and U.S. corporations are generally subject to U.S. income taxation on their worldwide income. To avoid double taxation of income earned abroad, the U.S. allows a credit for income taxes paid to foreign countries with respect to foreign source income. The U.S. also allows certain U.S. corporate shareholders in foreign corporations to claim a credit (known as the indirect or deemed-paid credit), generally in the year the foreign corporation pays a dividend, for foreign income taxes paid by the foreign corporation

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