5.7 International tax considerations
6 min read•august 21, 2024
International tax considerations are crucial for multinational corporations operating across borders. This topic explores how countries tax income from foreign sources and foreign entities within their borders, addressing complex rules and regulations governing cross-border financial transactions.
Key concepts include foreign vs. domestic income, foreign tax credits, , controlled foreign corporations, and tax treaties. Understanding these elements is essential for managing global tax liabilities and complying with international tax laws in the context of financial accounting.
Overview of international taxation
- International taxation encompasses the complex rules and regulations governing cross-border financial transactions and business activities
- Focuses on how countries tax income earned by their residents from foreign sources and income earned by foreign entities within their borders
- Plays a crucial role in Intermediate Financial Accounting 2 by addressing the tax implications of multinational corporations and global business operations
Types of international income
Foreign-source vs domestic-source income
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- Foreign-source income originates from activities or investments outside the taxpayer's home country
- Domestic-source income derives from activities or investments within the taxpayer's home country
- Determining the source of income impacts tax liability and available credits ()
- Includes factors such as location of property, place of performance for services, and residency of payers
Active vs passive income
- Active income results from direct participation in business operations or provision of services (salaries, business profits)
- Passive income stems from investments or activities requiring minimal effort (dividends, interest, royalties)
- Distinction affects tax treatment, with passive income often subject to different rates and limitations
- Impacts the application of various international tax provisions (Subpart F rules, PFIC regulations)
Foreign tax credit
Purpose and limitations
- Alleviates by allowing taxpayers to claim credit for foreign taxes paid on foreign-source income
- Prevents taxpayers from paying taxes on the same income to both their home country and foreign jurisdictions
- Limited to the lesser of foreign taxes paid or U.S. tax liability on foreign-source income
- Subject to separate limitations for different categories of income (general category, passive category)
Calculation methods
- Direct credit method allows taxpayers to claim credit for foreign taxes directly paid or accrued
- Indirect credit method (deemed paid credit) applies to corporate shareholders receiving dividends from foreign corporations
- Calculation involves determining foreign tax credit limitation:
- Excess credits can be carried back one year and forward up to ten years
Transfer pricing
Arm's length principle
- Requires related parties to set prices for intercompany transactions as if they were unrelated entities
- Ensures fair allocation of profits and prevents artificial shifting of income to low-tax jurisdictions
- Applies to tangible goods, services, intangibles, and financial transactions between related entities
- Methods include comparable uncontrolled price (CUP), resale price, cost plus, and profit split approaches
Documentation requirements
- Taxpayers must maintain contemporaneous documentation to support transfer pricing policies
- Includes functional analysis, economic analysis, and selection of appropriate transfer pricing method
- Master file provides overview of global business operations and transfer pricing policies
- Local file contains detailed information on specific intercompany transactions and their economic analysis
Controlled foreign corporations
Subpart F income
- Applies to certain types of income earned by controlled foreign corporations (CFCs)
- Includes passive income (dividends, interest, royalties) and certain types of active income
- U.S. shareholders must include their pro rata share of Subpart F income in current year taxable income
- Aims to prevent on easily movable income sources
GILTI provisions
- Global Intangible Low-Taxed Income (GILTI) targets income earned by CFCs that exceeds a deemed return on tangible assets
- Requires U.S. shareholders to include GILTI in their current year taxable income
- Calculation:
- Subject to a reduced effective tax rate through a deduction mechanism
Tax treaties
Double taxation avoidance
- Bilateral agreements between countries to prevent double taxation of the same income
- Provide mechanisms for allocating taxing rights between treaty partners
- Include tie-breaker rules for determining residency status of individuals and entities
- Establish procedures for mutual agreement and dispute resolution between tax authorities
Withholding tax rates
- Treaties often reduce or eliminate withholding taxes on cross-border payments
- Apply to various types of income (dividends, interest, royalties, technical service fees)
- Rates vary depending on the specific treaty and type of income
- Taxpayers must satisfy treaty eligibility requirements and provide necessary documentation to claim reduced rates
Permanent establishment
Definition and implications
- Concept used to determine when a business has sufficient presence in a foreign country to be subject to taxation
- Includes fixed place of business (office, branch, factory) or dependent agent acting on behalf of the enterprise
- Presence of a allows the host country to tax business profits attributable to that establishment
- Impacts corporate income tax liability, VAT registration, and employment tax obligations
Threshold for taxation
- Varies depending on domestic law and applicable tax treaties
- Physical presence test considers factors such as duration of activities and nature of facilities
- Digital permanent establishment concepts emerging to address taxation of digital economy
- Preparatory or auxiliary activities generally do not create a permanent establishment
Foreign currency transactions
Translation vs remeasurement
- Translation involves converting financial statements from functional currency to reporting currency
- Remeasurement applies to transactions denominated in a currency other than the functional currency
- Translation uses current exchange rates for balance sheet items and average rates for income statement items
- Remeasurement requires using historical exchange rates for non-monetary assets and liabilities
Functional currency determination
- Represents the primary economic environment in which an entity operates
- Factors include currency of sales prices, labor costs, materials, and financing activities
- Impacts the method used for foreign currency accounting (translation vs remeasurement)
- Highly inflationary economies require use of reporting currency as the functional currency
International tax planning
Tax havens vs substance requirements
- Tax havens offer low or zero tax rates and financial secrecy
- Substance requirements demand genuine economic activity and physical presence in low-tax jurisdictions
- Anti-avoidance measures target artificial arrangements lacking economic substance
- Includes concepts like controlled foreign company (CFC) rules and beneficial ownership tests
Base erosion and profit shifting
- -led initiative to combat tax avoidance strategies that exploit gaps in tax rules
- Addresses issues such as hybrid mismatch arrangements and treaty abuse
- Introduces country-by-country reporting requirements for large multinational enterprises
- Promotes development of multilateral instruments to implement tax treaty-related measures
Reporting requirements
FATCA compliance
- Foreign Account Tax Compliance Act (FATCA) requires foreign financial institutions to report U.S. account holders
- Aims to combat offshore tax evasion by U.S. persons
- Imposes 30% on certain U.S.-source payments to non-compliant foreign entities
- Requires U.S. taxpayers to report foreign financial assets exceeding specified thresholds
Country-by-country reporting
- Mandates large multinational enterprises to file annual reports detailing key elements of financial statements by jurisdiction
- Includes information on revenues, profits, taxes paid, employees, and tangible assets
- Enables tax authorities to assess transfer pricing risks and identify profit shifting activities
- Applies to multinational groups with annual consolidated group revenue exceeding €750 million
Recent developments
Digital services taxes
- Unilateral measures implemented by various countries to tax digital economy activities
- Target large tech companies providing digital services without physical presence
- Based on gross revenues from specific digital activities (online advertising, data sales)
- Creates potential for double taxation and international tax disputes
Global minimum tax initiatives
- OECD-led effort to establish a global minimum corporate tax rate (proposed at 15%)
- Aims to reduce tax competition and prevent profit shifting to low-tax jurisdictions
- Includes top-up tax mechanism to ensure effective taxation of multinational enterprises
- Challenges include implementation complexities and potential impact on investment incentives
Key Terms to Review (18)
Asc 740: ASC 740 refers to the Accounting Standards Codification Topic 740, which addresses income taxes and establishes standards for accounting for income taxes in financial statements. This standard provides guidance on how to recognize, measure, and disclose tax positions, while also addressing the complexities arising from differences between book income and taxable income, as well as the allocation of taxes within a reporting period.
Base Erosion and Profit Shifting (BEPS): Base Erosion and Profit Shifting (BEPS) refers to tax avoidance strategies employed by multinational companies that exploit gaps and mismatches in tax rules to shift profits from high-tax jurisdictions to low or no-tax jurisdictions. This practice can significantly reduce the tax base of countries, undermining their ability to collect revenue and maintain public services. BEPS is particularly important in international tax considerations as it highlights the need for coordinated efforts among countries to address these challenges and ensure fair taxation.
Comparable uncontrolled price method: The comparable uncontrolled price method is a pricing strategy used in transfer pricing to determine the appropriate price for transactions between related parties by comparing it to the price charged in similar transactions between unrelated parties. This method helps ensure that prices reflect fair market value, which is crucial for tax compliance and international trade.
Cost plus method: The cost plus method is a pricing strategy used by companies where the selling price is determined by adding a specific markup to the total cost of producing a product or service. This approach ensures that all costs, including materials, labor, and overhead, are covered while providing a profit margin. It is particularly relevant in contexts involving international transactions and tax considerations.
Double tax conventions: Double tax conventions are agreements between two countries to prevent the same income from being taxed by both jurisdictions, ensuring that individuals and corporations are not taxed twice on the same income. These treaties are crucial in international tax considerations, as they promote cross-border trade and investment by providing clarity on tax liabilities, reducing the risk of double taxation, and enabling efficient exchange of information between countries.
Double taxation: Double taxation refers to the taxation of the same income or financial transaction in more than one jurisdiction. This often occurs when a company earns income in a foreign country and is required to pay taxes both in that country and in its home country. The implications of double taxation are significant, as they can affect international business operations, investment decisions, and the overall economic relationship between nations.
Foreign currency translation: Foreign currency translation is the process of converting financial statements of a foreign subsidiary into the reporting currency of the parent company. This process is essential for multinational corporations as it ensures accurate financial reporting and compliance with accounting standards. The translation involves adjusting for differences in exchange rates, which can impact the overall financial position and performance of the parent company.
Foreign tax credit: A foreign tax credit is a provision that allows taxpayers to reduce their U.S. tax liability by the amount of foreign taxes they have paid or accrued on income earned outside the United States. This credit helps to alleviate the issue of double taxation, where a taxpayer would otherwise be taxed both by the foreign country and by the U.S. government on the same income. By using the foreign tax credit, individuals and corporations can effectively offset their U.S. tax obligations, making international business activities more feasible.
IFRS: IFRS, or International Financial Reporting Standards, are a set of accounting standards developed to provide a common global language for business affairs so that company accounts are understandable and comparable across international boundaries. These standards facilitate transparency and accountability in financial reporting, impacting various financial analyses and accounting practices worldwide.
Income tax provision: The income tax provision is an accounting entry that represents a company's estimated income tax expense for a given period, reflecting the taxes owed based on taxable income. It is crucial for financial reporting, as it provides insight into a company's tax obligations and is often influenced by the jurisdictional tax rates and regulations in which the company operates.
IRS: The IRS, or Internal Revenue Service, is the U.S. government agency responsible for tax collection and enforcement of tax laws. It plays a crucial role in managing and administering the federal tax system, ensuring compliance with tax regulations, and processing tax returns. Its functions are essential to understanding how international tax considerations impact individuals and businesses operating within and outside the United States.
OECD: The OECD, or Organisation for Economic Co-operation and Development, is an international organization founded in 1961 to promote policies that improve economic and social well-being around the world. It serves as a platform for governments to collaborate on various issues, including international tax considerations, which involve taxation policies, avoidance strategies, and the establishment of tax standards among member countries.
Permanent establishment: A permanent establishment refers to a fixed place of business through which an enterprise conducts its business activities in a foreign country. This concept is crucial for determining the tax obligations of multinational corporations, as it establishes whether they have a significant presence in a country that warrants taxation there.
Tax Deferral: Tax deferral is the postponement of tax liability to a future date, allowing individuals or businesses to delay paying taxes on income or gains until a later time. This concept is vital for financial planning, as it can provide immediate cash flow benefits and may lead to overall tax savings if the taxpayer’s rate decreases in the future. It often applies to retirement accounts, investments, and certain business structures that aim to maximize investment growth by delaying taxation.
Tax Information Exchange Agreements: Tax Information Exchange Agreements (TIEAs) are bilateral agreements between countries designed to facilitate the exchange of tax-related information. These agreements aim to combat tax evasion and enhance transparency in international financial transactions by allowing countries to share relevant information regarding taxpayers, including bank account details and income sources.
Tax residency: Tax residency refers to the status of an individual or entity that determines the jurisdiction in which they are subject to taxation. It is crucial in international tax considerations, as different countries have varying rules for determining tax residency, which can significantly affect tax obligations and liabilities for individuals and corporations engaged in cross-border activities.
Transfer pricing: Transfer pricing refers to the method by which related entities within a multinational corporation set prices for transactions involving the transfer of goods, services, or intellectual property between them. It is critical in ensuring compliance with tax regulations and can significantly impact the allocation of income and expenses among jurisdictions, affecting how uncertain tax positions are managed and international tax considerations are approached.
Withholding tax: Withholding tax is a government requirement for a payer to withhold a certain percentage of income when making payments to another party, typically in the context of salaries or dividends. This tax is usually collected by the employer or other entities and remitted directly to the government on behalf of the recipient. In the context of international taxation, withholding taxes are important as they can affect cross-border transactions and investments, impacting both the payer and payee in different jurisdictions.