13.1 U.S. Taxation of Foreign Income and Entities

The U.S. tax system for foreign income is complex, blending worldwide and territorial approaches. It impacts citizens, residents, and businesses with international ties. Key concepts include foreign tax credits, controlled foreign corporations, and special rules for various income types.

Understanding these rules is crucial for effective tax planning and compliance. From Subpart F income to transfer pricing, the system aims to balance revenue collection with global competitiveness. It's a dynamic area, constantly evolving with changing economic landscapes and policy priorities.

Worldwide vs Territorial Taxation

Taxation System Fundamentals

• Worldwide taxation system requires resident taxpayers to pay taxes on their global income, regardless of where it is earned
• Territorial taxation system limits taxation to income earned within the country's borders, generally exempting foreign-source income
• United States primarily uses a worldwide taxation system for its citizens and residents, with some exceptions and modifications
• Many countries employ a hybrid system, combining elements of both worldwide and territorial taxation (United Kingdom, Japan)

Mechanisms to Mitigate Double Taxation

• Foreign tax credits allow taxpayers to offset taxes paid to foreign governments against their domestic tax liability
• Tax treaties between countries establish rules for determining which country has the primary right to tax specific types of income
• Concept of tax residency crucial in determining which system applies to a taxpayer
  • Factors include physical presence, permanent home, center of vital interests

Global Trends and Implications

• Recent global trends show a shift towards more territorial-based systems, impacting international tax planning strategies
  • Examples: UK's transition to a territorial system in 2009, Japan's move in 2009
• Shift affects corporate decisions on repatriation of foreign earnings and global investment strategies
• Territorial systems may encourage companies to locate operations in low-tax jurisdictions

U.S. Taxation of Foreign Income

Types of Foreign-Source Income

• Foreign-source income includes wages, interest, dividends, capital gains, and business profits earned outside the United States
• Passive foreign investment company (PFIC) income subject to special tax rules and reporting requirements
  • PFICs typically foreign mutual funds or certain foreign corporations
• Foreign earned income exclusion allows qualifying U.S. citizens and residents to exclude a portion of their foreign earnings from U.S. taxation
  • 2023 exclusion amount: $120,000

Special Income Categories

• Subpart F income from controlled foreign corporations generally taxable to U.S. shareholders in the year earned, regardless of distribution
• Global Intangible Low-Taxed Income (GILTI) provisions subject certain foreign income to current U.S. taxation
  • Applies to income exceeding 10% return on tangible assets
• Foreign-derived intangible income (FDII) receives preferential tax treatment to encourage domestic corporations to export goods and services
  • Deduction available for portion of income derived from foreign sales or services

Transfer Pricing and Allocation Rules

• Transfer pricing rules affect how income from intercompany transactions with foreign affiliates is allocated and taxed
  • Arm's length principle requires pricing as if parties were unrelated
• Documentation requirements for transfer pricing transactions to support pricing methodologies
• Advance Pricing Agreements (APAs) allow taxpayers to negotiate transfer pricing methodologies with tax authorities in advance

Controlled Foreign Corporations (CFCs)

CFC Definition and Ownership Rules

• Controlled foreign corporation foreign corporation in which more than 50% of total combined voting power or value owned by U.S. shareholders
• U.S. shareholders defined as U.S. persons who own 10% or more of total combined voting power of all classes of stock entitled to vote in a foreign corporation
• Attribution rules apply when determining ownership percentages
  • Family attribution, corporate attribution, partnership attribution

Subpart F Income and Taxation

• Subpart F rules require U.S. shareholders to include their pro rata share of a CFC's Subpart F income in their gross income, regardless of distribution
• Categories of Subpart F income include foreign base company income, insurance income, and income from certain international boycotts
• Foreign base company income further divided into subcategories:
  • Foreign personal holding company income (passive income)
  • Foreign base company sales income
  • Foreign base company services income

CFC Special Rules and Reporting

• CFC look-through rule allows certain payments between related CFCs to be excluded from Subpart F income under specific conditions
• Global Intangible Low-Taxed Income (GILTI) provisions apply to income earned by CFCs that exceeds a 10% return on the CFC's tangible assets
• Form 5471 used to report information about CFCs and satisfy various reporting requirements for U.S. shareholders
  • Multiple categories of filers with different reporting obligations
  • Substantial penalties for failure to file or incomplete filing

Tax Treatment of Foreign Branches and Partnerships

Foreign Branch Taxation

• Foreign branches generally treated as an extension of the U.S. company for tax purposes, with income and losses flowing directly to the U.S. tax return
• Foreign branch income basket separates foreign branch income from other types of foreign-source income for foreign tax credit purposes
• Losses from foreign branch operations can typically be used to offset U.S. source income, subject to certain limitations
  • Dual consolidated loss rules may restrict use of certain foreign branch losses

Foreign Partnership Considerations

• Foreign partnerships generally treated as flow-through entities for U.S. tax purposes, with partners reporting their share of income on their individual returns
• Check-the-box regulations allow certain foreign entities to elect their classification as either a corporation or a partnership for U.S. tax purposes
  • Election made on Form 8832
• Special allocation rules apply to partnerships with foreign partners to ensure proper sourcing and character of income
  • Effectively Connected Income (ECI) rules for U.S. trade or business income

Reporting Requirements

• Form 8858 used to report information about foreign disregarded entities and foreign branches of U.S. persons and certain foreign corporations
• Form 8865 required for reporting interests in foreign partnerships
  • Different categories of filers based on ownership percentage and control
• Foreign Account Tax Compliance Act (FATCA) imposes additional reporting requirements for certain foreign financial assets
  • Form 8938 for individuals, Form 8966 for foreign financial institutions