United States and International Tax Law Considerations

Introduction

International tax issues impact businesses of every size in the global business environment. Tax considerations permeate not only the decision-making process of the largest enterprises but also those of many mid-sized and smaller companies. Similarly, individuals moving about and interacting in the world (in income-producing ways) must consider the various international tax systems at work. If you participate in cross-border transactions, chances are you will run into international tax issues.

When we speak about United States international tax law, we are generally dealing with the United States’ income tax system as it applies in an international context. The following high-level overview is meant to introduce some key concepts and principles in the area of United States international income tax law. It is our goal that armed with an introductory understanding of foundational principles, you may begin to engage critically with these topics and identify potential business areas where tax issues may manifest. To that end, please consider the following overarching question as we begin our study:

1. How has the United States determined which income items to tax and whom to tax?
2. What statutory steps has the United States taken to counter attempts by taxpayers to avoid United States taxation?

It should be noted that #2 above is specific to tax avoidance that misaligns with the United States’ determination under #1 above. For various policy reasons, the United States has chosen not to extend United States taxation to a considerable number of income types and taxpayers. Avoiding taxes through structuring or engaging in transactions in accordance with the United States’ intent not to extend taxation is legitimate. On the other hand, both the United States internal tax code and the tax treaties to which the United States is a party contain provisions preventing taxpayers from maneuvering to avoid taxes in ways that depart from the intent of the tax law.

Fundamental Considerations

According to President James Madison, “The power of taxing people and their property is essential to the very existence of government.”^[1] But how exactly should the government wield its tax power? Suppose that you were tasked with designing a new tax system for the United States. Some considerations you might have could include:

1. Should you tax based on worldwide income or limit taxation to income derived within your country (i.e. the home country)?
2. If the answer is worldwide income, are there any ways in which you would limit your tax reach? Alternatively, if the answer is to limit taxation to income derived within your country, are there exceptions where you would extend your tax reach?
3. How should tax on domestic taxpayers be determined and distinguished from foreign taxpayers?^[2]

In this chapter, we look at how the United States answers these fundamental questions. Different countries, however, have answered these questions differently. As such, even if you were to understand the relevant taxation approach under the United States income tax system, you cannot be sure another country would have a similar approach. Our focus here is on United States federal tax law. Even within the United States, however, state and local jurisdictions have their own separate rules that do not always track with the federal tax system. This is all to say that as with any other code-based system, guessing solely based on analogy is not a viable option when it comes to the international tax system. Often within the same transaction, you will need to consider the various autonomous tax systems at play and the authorities in place (such as bilateral tax treaties) that may coordinate the interactions of such systems.

United States federal tax law authority includes the following:

Code: The Internal Revenue Code of 1986, as amended

Regulations or Treas. Reg: The regulations promulgated under the Code by the United States Treasury as the Treasury’s official interpretation of the Code.

Besides the Regulations, the United States Internal Revenue Service (the “IRS”) publishes other official forms of tax guidance. These include notices, revenue rulings, revenue procedures, and announcements.^[3] In addition, tax law is often also informed by case law interpretation.

Approaches to Income Taxation

Income taxation can be categorized broadly into two approaches.

• Territorial: The country taxes income arising within its borders regardless of residence, nationality, or other status of the taxpayer.
• Worldwide: The country taxes income from all domestic and foreign sources of certain taxpayers connected to the country (generally by nationality or residence).

Although these categories are helpful in framing our tax considerations, tax systems rarely take a pure territorial or pure worldwide approach.^[4] The United States has historically taken a worldwide approach to income taxation, imposing a tax on the worldwide incomes of United States citizens, United States residents, and entities organized or chartered in the United States.^[5] The United States approach, however, has not been purely worldwide and has included elements of a territorial approach as well. For example, the United States allows foreign tax credits to offset certain foreign income taxes. In addition, although the United States has rules extending taxation to certain controlled foreign corporations and passive foreign investment companies, the United States also limits its income taxation reach with respect to certain foreign corporations beneficially owned by United States persons.^[6]

The Tax Cuts and Jobs Act, or the TCJA, Pub. L. No. 115-97 (2017), was enacted in December of 2017 and represented an overhaul of the United States tax system. Under the sweeping changes of the TCJA, the United States moved towards more of a territorial system for tax years after 2017.^[7]Under Code section 245A, domestic parent corporations now have a full tax deduction for dividends received from foreign affiliate corporations if the domestic parent owns at least 10% of the interests in the foreign subsidiary. This change eliminated in part, the United States tax on worldwide income earned abroad for certain companies. The TCJA, however, also included provisions taking a worldwide approach. For example, the TCJA included the imposition of current taxation on additional types of income earned abroad through controlled foreign corporations.^[8]As such the United States tax system can be described more accurately as a hybrid tax system.^[9]

 

Domestic or Foreign Tax Status

The United States taxes individuals and entities differently depending on their status as United States or foreign persons. Therefore, the first determination in analyzing United States taxation in a cross-border transaction is often the United States residency status of the taxpayer(s) at issue.

Domestic or Foreign Corporation

Under Code sections 7701(a)(4) and (5), a corporation’s status is determined on the basis of its site of incorporation.^[17] The United States’ tax treatment of a corporation based on the corporation’s site of formation uses an objective test which allows for simplicity, certainty, and administrative ease. This choice is not without policy drawbacks, however. For example, why should two companies both operating out of Belgium be treated differently simply because one was formed in Delaware and the other was formed in Brussels?^[18]

Individual Residence

The United States has also chosen to rely on largely objective tests to determine an individual’s residency status under Code section 7701(b).

In general, the United States taxes a resident alien on his worldwide income in the same manner as it taxes United States citizens. Thus, if an individual is treated as a “United States resident” for United States income tax purposes, the income they receive from both United States and non-United States sources may be subject to United States taxation.

Generally, an individual could be treated as a United States resident alien if they meet one of two tests – the “permanent resident test” (aka green card test) or the “substantial presence test.”^[19] They may also elect to be treated as a resident under certain circumstances if they meet the substantial presence test the following year (first-year election). Even if they meet the “substantial presence test,” however, they can avoid being treated as a United States resident if they can establish a closer connection with another country as discussed below.

In this chapter, we use the following terms:

United States Resident: An individual who (1) satisfies the permanent resident test (green card test), (2) satisfies the substantial presence test, or (3) has made a first-year election.

Nonresident Alien or NRA: An individual who is neither a United States citizen nor United States resident.

a. Permanent Resident (Green Card) Test

This test is relatively straightforward. An individual meets this test if they become a lawful permanent resident of the United States at any time during the calendar year, i.e., if they receive a green card.

i. Residency Start

If they are a lawful permanent resident of the United States at any time during the year and are not otherwise a resident alien during the year under the substantial presence test, their residency starting date is the first day in the calendar year on which they are physically present in the United States while holding a permanent residence visa.^[20]

ii. Residency Termination

Generally, the residency termination date is December 31 of the calendar year in which they cease to be a permanent resident.^[21] The individual’s residency can terminate before the end of the year, however, if they are no longer classified as a lawful permanent resident (assuming they are not otherwise a treated as a United States resident during the year under the substantial presence test), and if they show the IRS that his tax home was in a foreign country and that they have a closer connection to that foreign country than to the United States (the closer connection test).^[22]

b. Substantial Presence Test

An individual can also obtain United States resident status if they meet the substantial presence test. Since this is an objective, timeline test, someone staying in the United States may unwittingly satisfy the substantial presence test and be subject to United States taxation on their worldwide income if they are not careful.

i. General

An individual is considered to have met the substantial present test if they are physically present in the United States for 31 days in the current year and 183 days during the 3-year period that includes the current year and the two preceding years by counting (i) all the days they were present in the current year, (ii) 1/3 of the days they were present in the first preceding year, and (iii) 1/6 of the days they were present in the second preceding year.^[23]

Substantial Presence Test Calculation Chart

Included Year	Multiplier
Current Year	1
1st Preceding Year (i.e. Previous Year)	1/3
2nd Preceding Year (i.e. 2 years ago)	1/6

Example: Charlotte, a Korean citizen, is physically present in the United States for 120 days in 2021, 135 days in 2020 (the first preceding year), and 150 days in 2019 (the second preceding year). Charlotte is present in the United States for more than 31 days in 2021 and for more than 183 days over the relevant three-year period based on the calculations shown in the chart below. Charlotte would thus be substantially present in the United States for 2021 and unless an exception applies, must file a United States tax return for the year and be subject to United States income tax on her worldwide income.

Example Calculation

Year	Days
2021	1 x 120 = 120
2020	1/3 x 135 = 45
2019	1/6 x 150 = 25
Total	190 (>183 days)

In the above example, Charlotte will generally be treated as present in the United States on any day she is physically present in the United States at any time during the day.^[24] Certain days on which she is physically present in the United States, however, may be excluded. For example, Charlotte may exclude any days she was unable to leave the United States because of a medical condition that developed while she was in the United States^[25].

ii. Residency Start

In general, under the substantial presence test, the residency start date is the first day an individual is present in the United States during that calendar year.

iii. Residency Termination

The residency termination date under the substantial presence test is generally December 31 of the calendar year in which the individual leaves the United States (and is not a resident the following calendar year).^[26]The individual’s residency termination date may, however, be the last day on which they are physically present in the United States if they show the IRS that their tax home was in a foreign country and that they have a closer connection with that foreign country for the entire portion of the year after they leave the United States.^[27]

The residency termination date for an individual who satisfied both the substantial presence test and the green card test may be the later of the two termination dates under each test if the individual establishes that, for the remainder of the calendar year, their tax home was in a foreign country, and they maintained a closer connection to that foreign country than to the United States.^[28]

c. Closer Connection Exception

Even if an individual satisfies the substantial presence test, they will not be treated as a resident alien (and will not have to file a United States tax return) for any year in which they have a closer connection to, or more significant contacts with, a foreign country.

The individual must satisfy three requirements to qualify for this “closer connection” exception:

(1) they must be present in the United States during the current year for fewer than 183 days;

(2) they must have a tax home in a foreign country during the current year; and

(3) during the current year, they must have a closer connection to the foreign country where their tax home is located than they have with the United States.^[29]

A person can establish a closer connection to a foreign country by showing more significant contact with the foreign country than with the United States. For example, they can show that their home, family, personal belongings (e.g. automobiles jewelry, furniture, clothing), social and political organizations, routine personal bank, business, driver’s license, where they vote, and other forms and documents are located in the foreign country.^[30]

Example – Assume the same facts as above, except that during 2021, when Charlotte is physically present in the United States for 120 days (i.e. fewer than 183 days), Charlotte’s tax home is in Korea. Charlotte also establishes that, for the current year, she has a closer connection to Korea (where Charlotte’s spouse and children live) than she does to the United States Charlotte may claim the closer connection exception for 2021. Thus, even though Charlotte otherwise meets the substantial presence test for 2021, she does not have to file a United States tax return for the year.

The closer connection exception, however, is not available to an individual if they have taken affirmative steps to change their immigration status to that of a permanent resident during the year, or if they have an application pending for adjustment of status.^[31]

d. First Year Election

If an individual does not meet the permanent resident test or the substantial presence test for a particular year (i.e. the current year) or the prior year and does not choose to be treated as a United States resident for part of the prior year, but they meet the substantial presence test in the following year, they can also attach a statement to his income tax return choosing to be treated as a United States resident for part of the current year. To make this first-year choice, they must be present in the United States for at least 31 days in a row in the current year and be present in the United States for at least 75% of the number of days beginning with the first day of the 31-day period and ending with the last day of the current year. For purposes of this 75% requirement, 5 days of absence from the United States can be included as days of presence in the United States.^[32]

Sourcing rules

The United States has determined that it will tax United States source income differently from foreign source income for various purposes. The general source rules are found in Sections 861, 862, 863, and 865 of the Code. These source rules are important in determining the taxation of foreign persons as well as determining whether certain deductions, tax credits or exemptions are available. The United States categorizes different types of income and assigns rules to each category in determining whether such income is a United States source or a foreign source.^[33] Please see below for a chart of some sourcing rules based on income type:

Chart of Sourcing Based on Income Type

Type of Income	How to Determine Whether United States Source
Compensation for Personal Services	Where services are performed (Code §§861(a)(3) and 862(a)(3))
Rents and Royalties	Where property is located or used (Code §§861(a)(4) and 862(a)(4))
Sale of intangible property contingent on the use or productivity of the property	Where the property is used (same as royalty income) (Code §865(d)(1)(B))
Sales of personal property (other than inventory)	Seller’s residence (Code §865(a))
Sale of Inventory	Where title passes. (Code §§861(a)(6) and 862(a)(6)) (The income, however, may be allocated and apportioned between sources within and without the United States based on the production activities with respect to the property. Also, if the sale is attributable to a fixed place of business in the United States, the income may be U.S source regardless of where title passes unless certain exceptions apply.) (Code §863)
Sale of real property and natural resources	Where the property is located (75 Code §§861(a)(5) and 862(a)(5))
Dividends	Where payor is incorporated (i.e. if the payor is a United States company, then the income is United States sourced; if the payor is a foreign company, then the income is foreign sourced unless 25% or more of the company’s gross-income was effectively connected to a United States trade or business during the shorter of the company’s existence or a 3-year period test period.) (76 Code §§861(a)(2) and 862(a)(2))
Interest	Payor’s residence (Code §§861(a)(1) and 862(a)(1))

In addition to the rules reflected in the above chart, there are often various exceptions and complicated rules within each category. In addition, as noted in the case of inventory income, source rules may provide for the splitting of certain types of income between United States and non-United States sources. These may include income applicable to manufacturing, transportation, international communications, and property purchased in a United States possession and sold in the United States^[34]

The United States’ choice around its source rules does not reflect the only reasonable option. For example, in the United States, personal service income is sourced in the jurisdiction where the services are performed.^[35] If personal services are performed in part within the United States and in part out of the United States, income is apportioned between United States-source and foreign source.^[36] It does not matter who is receiving these services. Alternative choices for personal service income, however, could include:

1. Where the service provider resides;
2. Residence of the payor;
3. Where the service provider has significant contacts;
4. Location of the bank the service recipient uses to issue its payment check; and
5. Where payment to the service provider is received and deposited.

Different sourcing rules made by two countries may lead to incongruities that could lead to undesirable consequences such as double taxation of the same income. As will be discussed below, the United States has entered into bilateral treaties intended in part to help coordinate differing tax systems.

Basic Categories of Transactions

We turn next to the various transactions themselves that are covered by United States international tax rules. Transactions covered by the United States international tax rules can be divided broadly into two categories — outbound transactions and inbound transactions.

Here, we use the following terms:

• Multinational Corporation or MNC: Company operating business in both its home country and at least one other country
• Outbound Transaction: Transaction relating to the investment or the conduct of business by a United States person abroad

Example: Walmart, an MNC based in the United States selling products outside of the U.S

• Inbound Transaction: Transaction relating to the investment or the conduct of business by a foreign person within the U.S

Example: Toyota, Japanese MNC selling cars within U.S

Inbound Transactions

We consider first the overarching rules that govern the taxation of foreign persons in inbound transactions. The United States imposes income taxes on foreign persons under two tax regimes: (1) United States-source income not connected with a United States trade or business and (2) income connected with a United States trade or business.

a. United States Source Income Not Effectively-Connected with United States Trade or Business

i. General

The first category of items the United States will tax foreign corporations and NRAs generally include United States-source “fixed or determinable annual or periodical” (“FDAP”) income not connected with a United States trade or business and certain capital gains. FDAP income includes various types of passive investment income, such as interest, dividends, royalties, and rents.^[37] The taxation rules relating to this regime can be found in Code sections 871 (for NRAs) and 881 (for foreign corporations).

i. Tax Rate

If FDAP income received by a nonresident alien is determined to be United States sourced, and no exception applies it is taxed at a flat 30% rate.^[38] The tax obligation cannot be reduced by deductions.^[39] The 30% rate, however, may be reduced by a tax treaty. For example, under the United States-France treaty, the tax rate for dividends is reduced to 15%.^[40] The tax rate on dividends may be further reduced to 5% where dividends are paid to a company that owns, directly or indirectly, at least 10% of the capital of the payer company.^[41] The dividend rate may be further reduced to 0% where dividends are paid to a company that owns, directly or indirectly through residents of France and/or the United States, at least 80% of the capital of the payer company (and where various other criteria are met).^[42] Interests and royalties under the United States-France treaty are also reduced to 0%.^[43] Thus, once you establish that the United States tax applies to a particular type of FDAP income under its internal tax rules, you must also consider whether any applicable treaty may apply to modify the tax treatment.

ii. Exclusion for Certain Types of Capital Gain

The United States excludes certain types of United States source income not effectively connected with a United States trade or business from taxation. In particular, capital gains received by foreign corporations and NRAs from the sale of the assets held for investment are not subject to United States taxation unless the NRA has been in the United States for 183 days or more that year.^[44] For example, these could include gains from the sale of stocks, securities, and other financial assets. Thus, although a foreign person may be subject to United States tax on any dividends they receive from a United States corporation,^[45] they should not be subject to United States tax on the sale of the actual stock.^[46] Please note, however, that as described below, gains from the sale of real estate located in the United States are taxed by the U.S under the effectively-connected income rules described below.^[47]

• Example: Lance, a citizen and resident of France, buys United States stock at $10 a share and sells it at $50 a share three years later. Lance would not have to pay United States taxes on the $40 gain they realize from the sale. This gain escapes United States taxation. Domestic United States taxpayers, however, are generally subject to tax on the $40 gain.

iii. Portfolio Interest Exception

Another notable exception to United States taxation of foreign persons is interest received by foreign recipients that were derived from certain portfolio debt (i.e. interest paid on an obligation).^[48] From a policy standpoint, the “portfolio interest exception” promotes foreign investment in the United States Various requirements and carve-outs to the portfolio interest exception apply.^[49] We highlight only a couple here.

• The United States excludes from portfolio interest, certain types of contingent interest dependent on income or profits or on receipts, sales or other cash flow of the debtor or a related person.^[50]
• The portfolio interest exception also does not apply if the interest is received by an issuer company from certain shareholders holding at least 10% interest.^[51] From a policy standpoint, this rule limits the ability of MNCs to get a double benefit through loans with related foreign affiliates — the foreign affiliate could receive an exclusion of the interest received under the portfolio interest exception, and the United States company could get a deduction for the interest paid.

a. Effectively Connected Income

i. General

The second category of income tax to foreign persons by the United States includes income that is “effectively connected with the conduct of a trade or business within the U.S”, otherwise known as “effectively connected income” or “ECI”. In other words, these are income attributable to business activities of an NRA in the United States^[52] ECI includes both United States-source income as well as certain types of foreign-source business income.^[53] The rules for ECI are complicated and extensive. We cover some of these rules below.

i. Tax Rate

ECI is taxed at the same graduated rates as domestic persons (currently up to 37%) regardless of their source.^[54] Unlike in the case of FDAP income not effectively connected with a United States trade or business, the tax imposed on ECI may be reduced by deductions and credits. This can be particularly relevant where the income is foreign source income subject to taxation under the ECI rules.

i. Trade or Business

Whether something rises to the level of a trade or business is highly dependent on the facts.^[55] Trade or business is meant to cover only those activities that are sufficiently “considerable, continuous, and regular”^[56] For example, simply owning and receiving income from real estate may not rise to the level of a trade or business if the owner’s management of the property is not done so with continuity and regularity. In addition, simply owning or even trading in stock or securities may not be considered a trade or business unless there is evidence that the owner is a trader or dealer.^[57]

ii. Personal Services

An NRA’s compensation for the performance of personal services in the United States is generally ECI. There is a de minimis exception, however, for services performed by an NRA who is in the United States for 90 days or less, paid $3,000 or less, and under contract with persons meeting certain requirements.^[58]

iii. Force of Attraction

A nonresident alien or foreign corporation should not have any ECI unless it is engaged in a United States trade or business. Under Code section 864(c)(3), however, once a foreign person is engaged in a United States trade or business, all United States-source income of the foreign person is treated as effectively-connected (with the exception of certain capital gains and FDAP income). This “force of attraction” rule leads to potential pitfalls for non-United States taxpayers.

Example: A foreign corporation is engaged in the trade or business of purchasing and selling electronic equipment and establishes a United States branch office to sell this equipment. The foreign corporation’s home office is in the trade or business of purchasing and selling vintage wines. The United States office is not involved at all in the vintage wine business. Under the force of attraction principle, however, the United States-source income from the sale of vintage wines is treated as effectively connected with the United States trade or business.^[59]

iv. Effectively-Connected FDAP Income^[60]

Under Code section 864(c)(2), FDAP income may only be considered ECI if either (1) the income, gain, or loss is derived from assets used in or held for use in the conduct of the United States trade or business (the “Asset Use Test”) or (2) the activities of the United States trade or business were a material factor in the realization of the income, gain, or loss (the “Material Factors Test”).

A. Asset Use Test^[61]

Under the first test, an asset is “used in” or “held for use in” in the conduct of a United States trade or business if one of the following applies:

1. It is used principally to promote trade or business.^[62]

Example: If a German corporation is engaged in manufacturing in the United States, it may acquire stock in a United States corporation to provide for a consistent supply source for the United States factory. Dividends it receives from the United States corporation may be treated as “effectively connected income” since the stock was acquired to promote the United States trade or business.

    2. It is acquired and held in the ordinary course of the trade or business.^[63]

Example: As part of a U.K. company’s real estate business in the United States, it receives a note receivable from one of its tenants. The note receivable was acquired in the ordinary course of its real estate business, and interest received from the note is treated as “effectively connected income.”

     3. It is otherwise held in a direct relationship to the trade or business.^[64]

Example: A Luxembourg business owner accumulates funds from their United States business and invests that money in bonds. Payments from the bonds are available for use in the United States business and are “effectively connected income”.

Example: A Japanese corporation engages in the trade or business of renting out real estate in the United States The rent it receives is effectively connected under the Asset Use Test.

A. Material Factors Test^[65]

The Material Factors Test covers income from passive sources that directly relate to a foreign person’s trade or business.

• Example: Gains from selling shares in a corporation by a dealer in stocks and securities conducting his activities in the United States is considered ECI under the Material Factors Test.
• Example: Gains derived from the sale of capital accounts from an investment company conducting its trade or business in the United States are also considered ECI.

i. Real Property

A. Sale of Real Property

Many countries, including the United States, are particularly interested in taxing income associated with the sale of real estate located within their borders. Under the Foreign Investment in Real Property Tax Act of 1980 (“FIRPTA”), the gain or loss of a nonresident alien individual or foreign corporation from the disposition of a “United States real property interest” or “USRPI” is treated as ECI. The FIRPTA rules can be found in Code section 897. Before the enactment of FIRPTA, if the real property was held long enough, then a foreign person could avoid United States taxation relatively simply.^[66] For example, a foreign person could hold United States real estate through a corporation. The foreign person could then sell the interest in the corporation without paying any United States tax assuming such the person was not in the United States for 183 or more days.

This is no longer the case after the enactment of FIRPTA. The definition of USRPI found in Code section 897 is relatively broad and includes:

i) an interest in real property (including an interest in a mine, well, or other natural deposit) located in the United States or the Virgin Islands;^[67] and

(ii) an interest (other than an interest solely as a creditor) in certain domestic corporations that own (or have owned within the past 5 years prior to the disposition), United States real property interests constituting 50% or more of its real estate assets and assets used for its trade or business.^[68]

Thus, if the corporation’s assets reach the 50% threshold, a foreign person would be subject to United States taxation upon the sale of a stock interest in that corporation.

To ensure compliance with FIRPTA, Code section 1445 imposes withholding at the source in the amount of 15% of the amount realized (i.e. not just the gain, but the entire amount received for the property) when a foreigner sells USRPI.”^[69]

B. Election for Rental Income

Code sections 871(d) and 882(d)(1) provide that a foreign person may elect to treat rental income from United States real property as ECI. This is the case whether the person is engaged in a United States trade or business for the election year or not. If a foreign person makes the election to treat real property rental income as a trade or business, the income will be subject to graduated tax rates.^[70] The income, however, will then be eligible for deductions.^[71]

ii. Foreign-Source

The effectively-connected income regime also includes some foreign source income. This inclusion thwarts certain types of tax maneuvering, such as in the following example:

A foreign corporation operating out of a Chicago office selling snowplows might try to avoid United States taxation by structuring the sales to be foreign-sourced, i.e. by having title pass outside of the United States If the foreign corporation’s own country has no tax or if it takes a territorial approach to taxation and taxes income based only where the business was conducted, such a corporation could avoid paying income taxes altogether on the sale.

Under Code section 864(c)(4)(B), however, if a foreign person engaging in a United States business has an office or other fixed place of business in the United States, certain types of foreign-source income, if attributable to the United States office or fixed place of business, are effectively connected with the United States business. These include rent and royalties from intangibles, dividends, interest and other amounts from a banking or financing business and income from the sale of inventory.^[72]

Some types of foreign-source income that may be ECI include rents or royalties derived from the use outside the United States of intangible property originating from the United States business. Dividends, interest, and gains from securities derived from a United States banking business may also be considered ECI.^[73]

Various rules relate to the determination of whether a taxpayer has a “United States office or other fixed place of business.”^[74] The Regulations discuss these rules extensively and consider all facts and circumstances, e.g. the nature of the taxpayer’s trade or business, the activities performed, and the physical facilities used by the taxpayer in the ordinary course of its business.^[75]

In addition, the Code and Regulations also provide that only certain foreign-source income that is “allocable” to a United States office should be considered effectively connected.^[76] In general, the United States office must be a material factor in the realization of the foreign-source income for the income to be allocable in its entirety to such an office.^[77]

Branch Profits Tax^[78]

The branch profits tax, found in Code section 884 and the Regulations promulgated thereunder, is a 30% tax imposed on foreign corporations engaging in a trade or business in the United States through unincorporated United States branches. This acts as a substitute for the 30% withholding tax that would have otherwise been imposed by the United States for distributions of dividends if a foreign corporation operated in the United States through a United States subsidiary.

Generally, if a foreign corporation had a United States corporate subsidiary conducting its business in the United States, the company would be subject to two levels of tax. First, the United States corporate subsidiary would be subject to taxation as it earns its business income (currently at 21%). Next, the United States would tax the foreign parent corporation on dividends received by the United States subsidiary (at a rate of 30% unless reduced by treaty or if other exceptions apply). If a foreign person operated in the United States through an unincorporated branch, however, then the distribution out from the branch to the foreign company would not be taxed as a dividend. In order to ensure that the foreign corporation does not escape the second level of taxation on money distributed out from the United States, the United States imposes the 30% branch profits tax on the foreign parent.

Withholding at the Source

In order to overcome potential hurdles collecting taxes from foreign persons with limited contact with the United States, the United States uses a process of withholding at the source at flat withholding rates to collect FDAP income and other types of income from foreigners. These taxes are collected through Withholding Agents.^[79]

• Withholding Agent – Any foreign or domestic person that has control, receipt, custody, disposal, or payment of any item of income of a foreign person that is subject to withholding.^[80]

Withholding Agents are personally liable for any tax required to be withheld. This liability is independent of the tax liability of the foreign person to whom the payment is made. As such, Withholding Agents often require that recipients of United States source payments provide documentation providing United States tax status information.^[81]

Outbound Transactions

As noted above, the United States tax system historically took a limited worldwide approach to the taxation of its citizens and residents in outbound transactions. Although the worldwide income of United States citizens and residents was subject to United States tax, the allowance of foreign tax credits was used to limit the United States worldwide tax reach. In addition, the United States tax system allowed for a deferral of income earned abroad through a foreign corporation. Several elements of the historic tax system are still applicable. The historic tax deferral regime and worldwide approach to taxation of corporations, however, has been greatly curtailed by the TCJA as discussed below.

i. Foreign Tax Credit

Foreign tax credits or FTCs reduce the burden of double taxation on a country’s residents. The United States FTC under Code section 901 is generally a dollar-for-dollar foreign tax credit against United States taxes for foreign income taxes paid abroad. This has historically been available to domestic individuals and United States corporations as well as nonresident individuals and foreign corporations with effectively connected United States income. There are limitations to the FTC, however. For example, under Code section 904, the total amount of FTC taken under 901 cannot exceed the United States tax due on the item. This prevents the United States from having to pay refunds to companies operating in countries with high taxes.

The rules surrounding foreign tax credits are extremely complex and reflect measures the United States has taken to carve out legitimate vs. abusive tax structuring in international business transactions.

ii. Potential for Deferral

Because foreign corporations are treated as foreign persons, they are generally not subject to United States taxes unless their income is United States source income or is effectively connected with a United States trade or business. This means that certain United States persons holding interests in a foreign corporation would be able to avoid paying United States taxes currently on income earned by the foreign corporation. In general, United States persons would only have to pay United States taxes when the income is repatriated into the United States, i.e. when the foreign corporation issues dividends to the United States payer. It is possible for an individual United States shareholder of foreign corporate stock to avoid United States tax altogether if they hold the stock at death.^[82] Under Code section 1014(a), a beneficiary of an asset from a decedent, often receives a step-up in basis to the fair market value of the stock at the time of the decedent’s death. For example, if a United States person has a $10 basis for each share of foreign corporate stock (e.g. they paid $10 per share for the stock) and dies when the stock’s fair market value has increased to $50 a share, the asset would pass to his beneficiary at a basis of $50 at death. This means that if the person held onto stock in the foreign corporation until death, his beneficiaries could avoid paying any United States tax at all if they sold the stock the next day.

Residents of a higher-tax country may be tempted to artificially defer tax by using foreign entities organized in offshore low-tax jurisdictions to earn income through the use of a Controlled Foreign Corporation. In response, some countries such as the United States have special rules governing taxation of Controlled Foreign Corporations.

Controlled Foreign Corporation or CFC — A corporation that is registered and conducts business in a different jurisdiction or country (typically a low-tax jurisdiction or tax haven) than the residency of the controlling owners.

iii. Anti-Deferral for Subpart F Income

The United States has historically limited tax deferral by requiring current United States taxation on certain income earned by CFCs even if they remain undistributed. “Control” of the foreign company is defined in Code section 957 according to the percentage of shares owned by United States citizens and residents. To be considered a CFC by the United States, more than 50% (by vote or value) of the foreign corporation must be owned by United States persons, who must each own at least 10% of the value of the foreign corporation (“10% United States Shareholders”).^[83] 10% United States Shareholders of CFCs are subject to specific anti- tax deferral rules for certain types of income (“Subpart F Income”). Subpart F Income is proportionally attributed to the 10% United States Shareholders on a current (not-deferred) basis, which may require them to report and pay United States tax on earnings of the CFC even if these earnings are not yet distributed to the United States shareholder. Some examples of Subpart F income include insurance income from insuring risks outside a CFC’s country of incorporation, income from activities that take place in a different country as the country of incorporation, and income from unsanctioned international boycotts, illegal bribes, or certain blacklisted countries.^[84]

iv. Anti-Deferral for Passive Income

Even if the CFC rules do not apply, the “Passive Foreign Investment Company” or “PFIC” anti-deferral rules may apply if the foreign corporation holds significant passive assets. Under Code section 1297, PFIC generally applies where a United States person owns a foreign corporation that either (1) has at least 75% passive income or (2) if at least 50% of the foreign corporation’s assets produce passive income.^[85] PFIC income may be currently deferred but is then subject to a punitive interest charge when it is distributed to United States persons regardless of their interest percentage in the corporation.^[86] Alternatively, the United States shareholders can elect for the income to be subject to current taxation.^[87]

iv. Tax Cuts and Jobs Act

The TCJA made significant moves toward eliminating the regime allowing for the deferral of income and taxation at repatriation for companies described above.^[88] In the past domestic corporations would get a foreign tax credit for income tax paid on dividends received from overseas corporations. There is no longer a foreign tax credit or deduction for any overseas taxes paid or accrued on the qualifying dividend. After the TCJA, a United States corporation gets a 100% deduction for the foreign source portion of the dividends received from a foreign corporation in which it owns at least 10% of the stock under the dividends-received deduction rules of Code section 245A. This eliminated the imposition of United States tax at repatriation for certain companies. Furthermore, under the Global intangible low-taxed income (GILTI) rules of Code section 951A, the TJCA expanded the categories of income currently taxable for CFCs to include income from certain intangible property (under reduced tax rates).

An issue with a territorial tax system is that taxpayers may be incentivized to move their income-producing assets to low-tax countries. The following are some provisions under the TCJA intended to counteract this and incentivize MNCs to hold income-producing assets and business operations in the United States rather than in foreign countries.

• Global intangible low-taxed income (GILTI), the “stick”, imposes a 10.5% minimum tax (without deferral) on profits earned abroad in a CFC that exceed “normal” earnings (defined generally as 10% of the adjusted basis in tangible property held abroad). This imposes current taxation on certain types of income (generally intangible income).^[89]
• A deduction for foreign-derived intangible income (FDII) acts as a “carrot” to incentivize MNCs to hold intangible assets in their United States corporate affiliates. FDII is income received from exporting products whose intangible assets are held within the United States.^[90]

Example: A United States pharmaceutical company can deduct some income from drug sales in Europe if the patent on the drug is held in the United States parent company.

• Large foreign corporations with ECI may now need to pay the base erosion and anti-abuse tax (BEAT).^[91] BEAT imposes an additional tax on certain large corporate taxpayers that make “base erosion payments.” These include otherwise deductible payments such as royalties and interest and certain other types of payments that are paid generally from United States subsidiaries to certain foreign-related parties. ^[92]

v. FATCA and Information Reporting

Scofflaw United States persons may be tempted to avoid United States taxation by hiding money in offshore accounts. They may try to do so through either direct investments or indirectly through foreign entities. The Foreign Account Tax Compliance Act (FATCA), covered by Code sections 1471 through 1474, was enacted to identify and combat such tax evasion by United States persons holding accounts and other financial assets offshore. FATCA requires that foreign financial institutions (FFI) report to the United States information about their United States account holders and the foreign assets held in such accounts.^[93] Certain non-financial foreign entities (NFFE) must also report information about their substantial United States owners (i.e. United States owners who hold more than 10% interest). If they fail to do so, the FFIs and NFFEs may themselves be subject to 30% additional withholding on payments to them of certain categories of United States source FDAP.^[94]

In addition, FATCA requires that certain United States taxpayers who hold foreign financial assets with an aggregate value of more than the reporting threshold (at least $50,000) report information about those assets. The reporting threshold is higher for certain individuals including married taxpayers filing a joint annual income tax return and certain taxpayers living in a foreign country.^[95]

Tax Treaties

The United States has entered into tax treaties with over 50 foreign countries.^[96] Treaties may possess the authority to override or modify the tax treatment otherwise provided by the jurisdiction’s domestic tax legislation.^[97] In analyzing a cross-border transaction, you should generally consider first how a country’s internal rules would tax the item. Then, you should consider whether any tax treaty applies, and if so, how such a treaty might modify the taxation of that item.

a. Treaty Purpose

Functions that treaties provide include:

• Mitigate double taxation;
• Prevent fiscal evasion;
• Provide consistent rules governing the taxation of specific types of income such as business profits, income from real property, dividends, interest, and royalties;
• Determine which treaty country retains the right to tax particular types of income; and
• Apply rules to special types of persons, such as artists, athletes, students, trainees, and teachers.

As discussed above, the internal laws of each country governing the taxation of domestic and foreign persons do not always align with those of other countries. As such, a particular type of income may be subject to tax under multiple tax systems. The opposite may also occur in that neither system may tax a particular type of income. Tax treaties serve to coordinate the tax systems of different countries to avoid both double taxation and fiscal evasion. As such, treaties often have the effect of stimulating trade or investment between residents of treaty countries by eliminating economic barriers caused by double taxation.

a. Application to Treaty Residents Only

Treaty provisions apply to “residents” of one of the countries subject to the treaty. Note that the test for residency under a treaty may differ from the United States’ own residency rules. It is also possible for a person to satisfy the residency tests in both countries. Treaties often have tie-breaker rules where a person may fall under the definition of “resident” for both countries.^[98] This allows clarity as to which treaty country has the authority to tax such a person.

b. Treaty Benefits

Treaties generally function by providing rules that limit the ability of a treaty country to tax under its internal rules.^[99] Under many of the tax treaties the United States is a part of, dividends, interests, rents, royalties and certain non-real estate gains received by a resident of one treaty country from sources within the other treaty country are subject to reduced or, in some cases, no taxation by the source country.^[100] Thus, as described above, the 30% tax rate imposed on FDAP income may be reduced for foreign persons if they are residents of a treaty country.

Note, however, that United States treaties generally also have a “savings clause” which provides that the United States does not give up its rights to tax the worldwide income of its own citizens. As such, United States citizens are not permitted to avoid taxation from the United States through a treaty. This is true even if the United States citizen is a resident of the other treaty country.^[101]

Since a treaty generally only limits a treaty country’s ability to tax under its internal rules, it should not increase the tax burden.^[102] For example, suppose a treaty provides that the tax rate at which a source country can tax dividends is limited to 15%. To the extent the source country’s internal tax rate is higher (e.g. the United States which uses a 30% rate), the applicable tax rate will be reduced to 15%. To the extent it is already lower than 15%, the lower tax internal rate will apply.

United States tax treaties generally provide that the treaty will not be applied to deny and reduce any benefit accorded to any taxpayer under internal laws of either treaty country or other agreement between the treaty countries. If a United States resident believes it is more beneficial to do so, it may elect each year to remain subject to the United States internal tax system rather than avail itself of treaty benefits. Such a person, however, must then be consistent and apply United States’ internal tax law with respect to each type of income. They cannot pick and choose between the treaty and the Code depending on the type of income.^[103]

d. Limitation on Benefits

Given the benefits tax treaties afford its residents, taxpayers of a third country may be tempted to avail themselves of the benefits provided by a tax treaty even where they have no connections to either treaty country.

Treaty Shopping: where a resident of a third, non-treaty country seeks to obtain treaty benefits through the use of legal entities established in a treaty country with the principal purpose of availing itself of the benefits of the tax treaty.

• Example: A Belize corporation owns a United States corporation. The United States does not have a tax treaty in place with Belize. As such, dividends paid by the United States corporation are subject to 30% withholding tax. The Belize corporation may be tempted to form a corporation in Germany to hold the United States stock and avail itself of the treaty benefits under the United States-German tax treaty.

To prevent this type of treaty shopping, tax treaties in the United States generally contain a “limitation of benefits” clause with complex rules that operate to restrict treaty benefits to those individuals and entities with sufficient relationship to be considered legitimately connected to the treaty country. For example, under these rules, the treaty may have tests that look at the residency status of the beneficial owners of a company (the ownership test) and/or the residency status of the recipients of the company’s income (base erosion test) to determine whether treaty benefits may apply.^[104]

Mitigating Taxation – Tax Laws and Ethical Tax-Related Decisions

Transfer Pricing

Transfer pricing is the price that one division in a company charges another division for goods and services provided – as distinct from the price the company would charge an independent third-party entity. In other words, by virtue of the relationship between different divisions or distinct entities in the same multinational enterprise, they can offer favorable pricing to one another. This way, subsidiaries and affiliates of the same multinational enterprise – those entities essentially or commonly controlled by the same larger enterprise – can agree on pricing that is distinct from the pricing structure offered to outsiders.

First, it is important to cover basic vocabulary to enhance understanding of transfer pricing concepts.

• “Arm’s-Length Price.” An arm’s length price is the price charged in a transaction between unrelated parties. That is entities that are not affiliates, subsidiaries, or otherwise commonly owned.
• “Transfer Price.” This is the price charged in a transaction between two associated enterprises. As it might be inferred, this price can be much more favorable and quite different from the arm’s length price.
• “Uncontrolled transactions.” These are the transactions that accompany the arm’s length price – those between two unrelated parties.
• “Controlled Transactions.” Those transactions where transfer pricing becomes possible – transactions between two associated enterprises or related parties.

Moving on to the discussion of transfer pricing: a transfer price is a price used to decide the cost one division, subsidiary, affiliate or holding company charges its affiliate entity for goods or services rendered. Note that transfer pricing can also be applied to intellectual property, so patents, trademarks, royalties, and research are included. It comes into play here, in this textbook, because multinational enterprises are legally allowed to use transfer pricing methods in the context of controlled transactions to determine how to allocate their collective resources among their various affiliate entities. Although multinational enterprises are not permitted to engage in transfer pricing purely to avoid tax liability, they do exactly this, frequently.

How can transfer pricing be used to reduce tax liabilities? This is best understood in the context of a scenario.:

A fashion entity has two divisions: Division A, which is a jean design entity, and Division B, which is essentially a manufacturing facility for denim jeans.

Division A licenses intellectual property – the jean label and the design specs – to Division B, which then actually makes the jeans and distributes them to retailers. Division B pays Division A for the license, typically at the prevailing market price that Division A charges other jean-making facilities – so the same as arm’s length prices offered in uncontrolled transactions.

Now, Division A decides to charge a lower price to Division B for the use of the license, instead of using the market price. As a result, Division A’s sales or revenues are lower because of the lower pricing. On the other hand, Division B’s costs of goods sold are lower, increasing the division’s profits. In short, Division A’s revenues are lower by the same amount as Division B’s cost savings—as a result there is no financial impact on the overall corporation – on the multinational enterprise that owns both entities.

But – what if Division A is in a higher tax country, such as France – than Division B – such as Germany. The overall company can save a ton on taxes by making Division A less profitable and Division B more profitable. By making Division A charge lower prices and pass those savings onto Division B, boosting its profits through a lower cost of goods, Division B then, which is where the bulk of the profits are sitting, is the one in the country with the lower tax rate. In other words, Division A’s decision not to charge market pricing to Division B allows the overall company to evade taxes.

In short, by charging above or below the market price, companies can use transfer pricing to transfer profits and costs to other divisions internally to reduce their tax burden. While this is legal and one of the advantages of being structured as a Multinational Enterprise, tax authorities do have rules about transfer pricing in controlled transactions.

Mitigating Taxation – Tax Laws and Ethical Tax-Related Decisions

1. Amazon

• In 2019, Amazon became the second US country to reach a valuation of $1 trillion, after Apple^[105] However, in 2019, Amazon paid $0 in federal income tax. Amazon also paid $0 in federal income tax in 2018 and 2017^[106] According to Business Insider, Amazon actually received hundreds of millions of dollars in federal tax credits in both 2017 and 2018^[107] US tax code enables companies like Amazon to avoid paying the standard corporate rate, and Trump’s Tax Cuts and Job Acts of 2017 facilitate this further. Amazon uses legal tax breaks to steeply reduce their income tax liabilities^[108]
  • “This is tax avoidance, not evasion. There’s no indication of any wrongdoing, except on the part of Congress,” – Matthew Gardner^[109] (senior fellow at the Institute of Taxation and Economic Policy)
• Critics have used Amazon as a prime example of flaws in “an unbalanced, loophole-ridden corporate tax system” of the United States^[110] However, proponents have used Amazon as an example of why the US tax code works, stating that Amazon provides thousands of jobs and grows the US economy and that tax breaks give incentives for Amazon to reinvest profits and stimulate growth^[111]

2. Starbucks

• As of 2020, Starbucks is the world’s third largest restaurant/café chain with over thirty thousand stores worldwide. In 2015, the European Commission accused Starbucks of setting prices for goods and services between their subsidiaries (transfer pricing) that were far below market rates, a move that artificially lowered their taxes.^[112] The European Commission stated that an APA issued by the Dutch tax authorities to Starbucks constituted state aid by The Netherlands to Starbucks.^[113] The European Commission also stated that Starbucks benefited from an illegal tax deal with The Netherlands.^[114] The European Commission ordered The Netherlands to collect over 25 million euros in taxes from Starbucks.^[115]
• Starbucks criticized the European Commission’s assessment and both Starbucks and The Netherlands filed an appeal. In 2019, the General Court of the European Union issued its judgment and concluded that “Starbuck’s Dutch APA regarding the arm’s-length remuneration of a Starbucks entity performing group functions in The Netherlands was held not to constitute state aid”^[116] The European Commission lost the case against Starbucks on the burden of proof^[117]

Abuse and Responses to Unethical Tax Mitigation

From a tax point of view, transfer pricing practices are vulnerable to abuse where an enterprise with subsidiaries and affiliates in different countries manipulates the prices charged to and by their various subsidiaries and affiliates to shift income away from the United States and into tax-favored jurisdictions.

Because related parties—i.e., members of a single corporate entity—generally care more about their global profit than where profit is reported, it is in their interest as a group to report more profit in jurisdictions with comparatively low tax rates, thereby raising the profits of the group overall.

As mentioned previously, this manipulation is typically accomplished by causing the corporate subsidiary in the United States (or other “high tax” jurisdiction) to sell goods to the foreign subsidiary at below-market rates, or to buy goods from that foreign subsidiary at above-market rates, so that any profit from the ultimate sale of those goods to a third party is attributed to the foreign subsidiary. For our purposes, we will focus on the tax laws of the United States itself and the ways in which they protect against such abuses.

Section 482 of the Internal Revenue Code is designed to prevent this sort of transfer pricing abuse. The IRS Code and enforcing regulations provide taxpayers with substantial flexibility in setting their transfer prices and a range of options as to how to calculate these prices.

However, transfer prices “arranged solely to avoid taxes and without a valid business purpose” are plainly impermissible.”

Under IRS Code Section 482, the IRS can actually re-allocate income between related entities to prevent tax evasion – essentially changing the prices for which goods and services were exchanged between the two affiliate entities – in other words, changing the pricing structure to reflect the “true income” of the relevant businesses. Here, the “true income” of a taxpayer means “the taxable income that would have resulted had it dealt with the [related party] at arm’s length.” 26 C.F.R. § 1.482-1(i)(9). In addition, the IRS determines what would have been the “true income” by essentially simulating an “arm’s length” transaction using economic models.

IRS leadership, on numerous occasions, has commented on the importance of abusive transfer pricing as an international taxation issue. In addition, the IRS has also collected significant sums from multi-national corporations based on allegations of transfer mispricing.

Examples of IRS lawsuits include one against the Coca-Cola company, which transferred various intellectual property to subsidiaries in Africa, Europe, and South America between 2007 and 2009 in a $3.3 billion transfer pricing arrangement; and another IRS lawsuit against Facebook, which transferred $6.5 billion of intangible assets to Ireland in 2010, thereby cutting its tax bill significantly. In the Facebook case, by the way, if the IRS wins, Facebook may have to pay as much as $5 billion in additional taxes, interests and penalties.

Other Potential Solutions

Besides the rules promulgated by the IRS (and the treasury department) to curb transfer pricing abuses in the United States, there have been other suggestions on how this abuse can be prevented.

Some scholars have suggested changing taxation laws altogether, particularly as they pertain to multinational enterprises, to more global-oriented structures, namely, “formulary apportionment.”

The formulary apportionment model would focus on the global net income of a business, regardless of where various aspects of that business were earned, and tax it as a lump amount. It is taxed on the net level, so expenses are subtracted, but the taxes are placed on the net worldwide income – on that one number. Then, you would have to apportion the income between the countries where the various aspects of the Multinational Enterprise are based, and there would be a formula for that apportionment. Then, each country’s own domestic tax rates laws would be applied to that country’s portion of the income. Using this method would, indeed, go a long way toward preventing tax-abusive business practices designed to lower tax burdens. But is there a chance for this approach to actually catch on beyond the scholarly suggestion? Not so far.

Governments could also attempt to influence taxpayer behavior. Typically, a corporation’s decision to engage in the “gray” transactions, those that are not necessarily legal or illegal, have to do with a risk-benefit analysis. In such a risk assessment, the business would determine (1) the likelihood of being audited; (2) the likelihood that such a prospective audit would find the company’s tax position is illegal; and (3) the amount of penalties that would be imposed should that happen.

The third part of the analysis, what penalties would apply, can be calculated with some reasonable accuracy. But the first and second parts of this analysis – the likelihood of being audited and the likelihood of being found guilty – are very difficult if not impossible. After all, most companies do not know the likelihood of being audited – the IRS keeps the details of which taxpayers get audited secret.

If a corporation is not certain whether the IRS will pursue it with an audit for its violations, and there is a chance that the IRS will not do so, the corporation is more likely to take the risk of improper conduct – particularly if it is more of a grey line rather than a black and white one that is being crossed. In addition, because IRS lawsuits go to judges (which companies find to be more business-friendly than juries), this also increases the likelihood that the company would engage in improper practice.

What if we could change the risk analysis in a way that encourages corporate taxpayers to avoid abusive tax practices as they pertain to transfer pricing? Some scholars have suggested that we should strip the United States Tax Court of its jurisdiction in transfer pricing cases, and force businesses into a forum where the disputed tax must be paid upfront and the government would be able to insist that a jury serves as the fact-finder. It is thought that this change would decrease the likelihood that businesses would use aggressive transfer pricing taxes to avoid taxation.

So far, there is no real reason for such a change. As a result, for now, it will be up to the IRS to do what it can to deal with abusive practices, and up to each individual corporate leader engaging in global transactions, doing their best to be as ethical as possible.