International Business Taxation
All countries of the world assess taxes on businesses, but there are differences in tax systems, tax rates, business incentive provisions, and compliance requirements. Furthermore, many countries assess tax on its citizens and domestic corporations, regardless of where they earn the income.
Generally, other countries assess the same types of taxes as the United States (US), such as taxes on income or profits, payroll taxes, and consumption taxes, such as sales, excise, and value-added taxes. Value-added taxes are much more prevalent in Europe and account for much of the governments' tax revenue. However, the methods of calculating taxable income and the tax rates will differ from country to country. Different countries also allow different methods of depreciation, with the straight line method being more prevalent than the declining balance method.
With regard to the US, international business transactions can be classified into 2 categories. Outbound transactions are transactions in which US citizens or residents, and domestic corporations invest or do business abroad. Inbound transactions are transactions that nonresident aliens and foreign corporations invest or do business in the US. Both types of transactions are taxable by the US. Without inbound taxation, domestic businesses can be at a disadvantage to foreign corporations operating within the United States if their foreign taxes are lower than US taxes.
The US government has the authority to levy tax on any income earned by US citizens, residents, and domestic corporations, regardless of where they live or do business and on foreigners doing business within the US. This can lead to double taxation issues, where the taxpayer not only must pay US taxes but also foreign taxes.
The taxation of international transactions depends on both the law of the relevant countries and on any current treaties between the respective countries. Cross-border transactions involving the US are based on both the Internal Revenue Code and tax treaties, which are bilateral agreements between countries to lessen the tax burden for those people who conduct business across borders. Tax treaty provisions generally supersede US and foreign tax law.
Although both countries have the right to tax either its citizens or foreigners operating within the country, tax treaties generally give primary taxing rights to one country while the other country is required to provide tax credits, lower tax rates, or special exclusions from taxation to lessen the otherwise burdensome double taxation. Of course, double taxation is not evil per se, but it can lead to excessive taxation, since, as a practical matter, the tax code of any country does not usually consider the tax burden that other countries may impose on the citizens operating in those other countries. The tax code of most countries primarily deal with taxpayers who live and work domestically. The country with the primary taxing power depends on the taxpayer's residence or whether there is a permanent business establishment in the country.
The US has tax treaties with more than 50 countries. US treaties are generally based on the United States Model Income Tax Convention, written in 1996 and last modified in 2006. Most treaties involving the US are a modification of this model treaty, with differences among the treaties depending on the specific country.
One basic tenet of the model treaty is that the foreign country will not tax a US business if it does not have a permanent establishment in the foreign country, meaning a branch or other place of business located in the foreign country — called a physical nexus. However, sites for storage, delivery, display, or purchase of merchandise; for advertisements; or for the collection of information or scientific research do not qualify as a physical nexus.
Foreign Tax Credit for Corporations
The US offers a foreign tax credit (FTC) for corporations that can be applied to income that is taxable by both the US and the foreign country. (There is also a foreign tax credit for individuals and other business entities.) Corporations must file Form 1118, Foreign Tax Credit — Corporations to claim the FTC. The FTC can be applied to foreign income and trade taxes, but not to foreign property taxes, value-added taxes, sales taxes or any other levy that is not based on taxable income. However, these other expenses are deductible as business expenses.
Generally, the maximum FTC equals the tax on income from foreign sources by the US for any given tax year.
Maximum FTC Allowable = Foreign Source Taxable Income/Worldwide Taxable Income × US Tax on Worldwide Taxable Income before Credits
Any unused foreign tax credits can be carried back 2 years or forward 5 years, but the FTC limit applies to each of those years.
Generally, the FTC must be applied to taxes paid on categories of income called baskets, which includes:
- passive income, such as from interest or dividends from investments;
- high withholding tax interest income, which the tax code defines as income subject to a foreign withholding tax of 5% or more;
- Section 901(j) income, which is income received from sanctioned countries, which currently includes Cuba, Iran, North Korea, Sudan, and Syria. Sanctioned countries are considered those who sponsor terrorism, countries with no diplomatic relationship with the US, and governments that are not recognized by the US;
- re-sourced income, which is income that would ordinarily be treated as US sourced income, but is re-sourced by treaty;
- general category income is any income not covered by the above classifications.
The purpose for dividing income into baskets is to prevent averaging of the income among high-tax and low-tax countries involving different types of income. A separate Form 1118 must be filed for each type of income.
Sourcing of Income and Deductions
The amount of FTC that can be claimed depends on the amount of foreign income. How foreign income is taxed depends on the activities, the type of income, and the involved tax jurisdictions. IRC §§861-865 list detailed rules for sourcing income and deductions according to country.
Although regulations are complex, the following rules apply in most cases:
- income from services is sourced to the country in which the services are performed;
- rental income earned from tangible property is sourced at the property's location;
- royalty income earned by intangible property is sourced to the country of use;
- interest income, to the debtor's country of residence;
- dividend income, to the country where the dividend paying corporation is incorporated;
- real estate sales are sourced to the property's location;
- personal property is sourced to the seller's country of residence or incorporation;
- income from the sale of purchased inventory, to the location where title is transferred;
- the sale of manufactured inventory, to the country of the manufacturer; and
- because money is fungible, interest expense is allocated among the different countries based on the assets involved.
When depreciable personal property is sold, then a portion of the gain is considered a recapture of the depreciation and must be sourced to the location where the income was reduced by the depreciation deduction. Any remaining gains are sourced to the location in which the title transfers.
Taxpayers generally consider how to arrange their international affairs so as to prevent double taxation and to use the complex laws to reduce or avoid taxes, especially by manipulating transfer pricing. However, IRC §482 grants the IRS broad powers to reallocate both income and expenses to better reflect income.
Taxation of Legal Forms of Foreign Operations
Taxation of foreign income depends on the legal form in which the company conducts its business in the foreign country. There are several ways that a company can market its products or services without having a foreign presence. It can hire foreign sales representatives or it can license its patents or trademarks to foreign companies. How that income is taxed depends on the tax treaty, if one exists, between the US and the foreign country.
Many companies, however, desire or require a foreign presence in the country. A corporation can establish a branch in the foreign country, which will be subject not only to the foreign taxes of the country but also to US tax. However, the US tax can be offset by the FTC. A corporation can also establish a partnership with other businesses in the foreign country, in which case, the corporation's partnership interest will be taxed in the same way that partners are taxed in the US. Taxes on the partnership income can also be offset by the FTC.
A corporation can also form a controlled subsidiary located in the foreign country that is either incorporated in the US or in the foreign country. Controlled subsidiaries have both business and tax advantages. The controlled subsidiary is an independent business entity with the controlling corporation as the major, and often times, the only shareholder.
Controlled subsidiaries are often formed because the foreign ownership of businesses is restricted in many countries, and where it is not, there is often a branch profits tax assessed on foreign corporations with a branch within the country. If a controlled foreign subsidiary is incorporated under US law, then it is taxed under general corporate rules. Any dividends paid by the subsidiary to the parent qualify for the 100% dividends-received deduction. The parent corporation files a consolidated tax return, including the income and deductions of the foreign subsidiary. Any tax due on subsidiary profits can be offset with the FTC.
The main tax advantage of a controlled foreign subsidiary is that its income is not includable in the parent's consolidated tax return, and, thus, is not taxed by the US when the income is earned, but only when the income is repatriated to the US in the form of dividends. However, the foreign subsidiary does have to pay taxes to the country in which it is located and dividend payments to the US parent may also be subject to foreign tax. Hence, many corporations select low tax jurisdictions, like Ireland, with its 12.5% corporate tax rate, in which to locate a controlled foreign subsidiary.
Dividends are not eligible for the dividends-received deduction, so they are taxed when they are paid to the parent corporation. Although the parent corporation must recognize the dividend income equal to the gross earnings before taxes, the US allows a deemed paid foreign tax credit for the applicable amount of tax paid.
Taxable Dividend Income =
- Net Dividend Received
- + Foreign Withholding Tax on Dividend Distribution
- + Foreign Taxes Paid by the Foreign Subsidiary on the Income for Which the Dividend Was Distributed
TCJA Changes to International Taxation
The 2017 Tax Cuts and Jobs Act (TCJA) changed how the federal government taxes income on what US resident multinational firms earn in foreign countries. The TCJA introduced 3 major provisions to improve the collection of taxes from multinational firms: the Base Erosion and Anti-Abuse (BEAT) Tax, Global Intangible Low-Taxed Income, and the Foreign-Derived Intangible Income (FDII) Tax.
TCJA also introduced a special tax rate for Foreign Derived Intangible Income (FDII)—the profit a firm receives from US-based intangible assets used to generate export income for US firms. An example is the income US pharmaceutical companies receive from foreign sales attributable to patents held in the United States. The maximum rate on FDII is 13.125%, rising to 16.406% after 2025. FDII aims to encourage US multinationals to report their intangible profits to the United States instead of to low-tax foreign countries.
The BEAT is based on an alternative calculation of tax liability, whereas FDII and GILTI describe a particular type of income taxed under the TCJA.
Base Erosion and Anti-Abuse (BEAT) Tax
When the United States moved to a territorial tax system under the TCJA, provisions of the tax code were added to reduce the likelihood that companies would move profits to low tax jurisdictions by claiming inflated deductions paid to these foreign subsidiaries. One of these provisions was Section 59A (Tax on Base Erosion Payments of Taxpayers with Substantial Gross Receipts).
The Base Erosion and Anti-Abuse Tax (BEAT) of Section 59A taxes these large corporations if their inflated deductions paid or accrued to foreign related parties, called base erosion payments, exceeded 3% of their total deductions (2% for certain banks or registered securities dealers), herein referred to as the base erosion percentage test. The BEAT is a minimum tax, much like the alternative minimum tax. Additional tax under the BEAT is only assessed if the BEAT tax rate multiplied by the taxpayer's modified taxable income exceeds the taxpayer's regular tax liability, adjusted for certain credits.
In the United States, many corporations reduced their taxes by making inflated payments, such as royalties, interest, reinsurance, payments for intellectual property, and similar payments, to foreign subsidiaries located in low-tax jurisdictions to claim as deductions on US tax returns as a way to lower taxable income within the United States.
This tax applies only to large corporations, excluding regulated investment companies, a real estate investment trust (REIT), or S corporations, satisfying the gross receipts test who reduced their U.S. tax liabilities by making inflated deductible payments to foreign related parties. A company satisfies the gross receipts test if its average annual gross receipts during the 3 tax years preceding the current year was at least $500 million.
Instructions for Form 8991 (12/2020) | Internal Revenue Service
The calculation of this tax is calculated like the regular tax liability, but by disallowing certain deductions of payments to foreign subsidiaries that greatly lowered US taxable income. The tax code refers to these deductions as base erosion tax benefits because they erode the tax basis for United States taxable income. If 10% of this modified taxable income exceeds the regular tax liability after adjusting for certain credits, then the difference is added to the company's tax liability.
Adjusted Regular Tax Liability = Regular Tax Liability − Certain Tax Credits
Modified Taxable Income = Regular Taxable Income + Base Erosion Tax Benefits
BEAT = 10% of Modified Taxable Income − Adjusted Regular Tax Liability
This calculation is much like the calculation for the alternative minimum tax, where tax liability must be calculated in 2 different ways and if the alternative minimum tax exceeds the regular tax, then the difference is added to the taxpayer's tax liability.
Modified taxable income may also be increased if the company had net operating losses, which is multiplied by a base erosion percentage.
Base Erosion Percentage = Base Erosion Tax Benefits/(Aggregate Amount of Certain Allowed Deductions + Base Erosion Tax Benefits)
Before 2026, adjusted regular tax liability is reduced by certain credits, such as the R&D tax credit, the low-income housing credit, renewable electricity production credit, and a portion of the investment credit that can be allocated to the energy credit under §48. In 2026 and thereafter, the adjusted regular tax liability will be reduced by all credits.
The GILTI − Global Intangible Low-Taxed Income − tax sets a minimum tax on income exceeding what policymakers determined to be a normal rate of return of 10% on tangible assets, equal to an effective tax rate of 10.5% till 2025, then 13.125% thereafter. These lower rates arise because the taxpayer can deduct 50% of the GILTI until 2025, then 37.5% thereafter, to the 21% corporate tax rate that would otherwise apply. There is also a foreign tax credit that can offset the GILTI tax liability, but that credit is limited to 80% of the foreign taxes paid.
GILTI income = income earned by a U.S. foreign subsidiary exceeding 10% of a foreign subsidiary's qualified business asset investment (QBAI). QBAI is the depreciated tangible assets, such as machines and other equipment, of the foreign subsidiary.
A primary target of the GILTI provisions are patents transferred to low-tax jurisdictions so that the income earned by those patents will be taxed at lower rates, even though there is little actual investment in the low-tax jurisdiction. Often, these so-called investments are actually just rented offices that hold expensive patents. Moreover, these patent offices can license their patents at high rates to subsidiaries, which would allow the subsidiaries to claim these high payments as deductions in high-tax jurisdictions.
Here is a very simplified example. Consider a technology company with an office in Ireland with $1000 worth of office equipment earning $1 million from patents held at that office. A 10% return on $1000 of office equipment equals $100, which means that the technology company would have to report on its US income tax return $1,000,000 minus the $100 of income that would normally be earned from the $1000 investment. So the company would have to report $9,999,900 on its tax return. Since the company can claim a deduction of 50% on the taxable income, it would have to pay 10.5% of the $9,999,900 of GILTI income. If a company paid $125,000, 12.5% of that income, in taxes to Ireland, then they can deduct 80% of that amount from its U.S. tax liability. Thus, it's combined tax liability would equal the tax paid to Ireland plus the tax paid to the US.
Foreign-Derived Intangible Income (FDII) Tax
Another provision of the TCJA targeting the use of intellectual property in tax avoidance schemes is the foreign-derived intangible income (FDII), defined as the income from a sale or provision of intangible U.S. goods and services to foreign entities or for a foreign use. The main purpose of this provision is to motivate companies to locate their intellectual property (IP) domestically rather than in foreign countries, somewhat like patent boxes in other countries, where IP-derived income is taxed at lower rates, by taxing it at lower rates than other income. Taxes are reduced by providing a 37.5% deduction against FDII, which reduces the effective tax rate to 13.125%. However, starting in 2026, this deduction is reduced to 21.875%, yielding an effective tax rate of 16.406%, which is still less than the general 21% corporate tax rate that would otherwise apply.
The deductions for FDII and GILTI are calculated together on Form 8993, Section 250 Deduction for Foreign-Derived Intangible Income (FDII) and Global Intangible Low-Taxed Income (GILTI).
Steps for Computing the Deduction Under Section 250
- Determine Deduction Eligible Income (DEI)
- DEI = (gross income − exclusions) − ( deductions, including taxes, allocable to that gross income).
- Determine Deemed Tangible Income Return (DTIR), which is a corporation's qualified business asset investment (QBAI), tangible property used to earn DEI, multiplied by 10%.
- DTIR = QBAI * 10%
- Determine Deemed Intangible Income (DII)
- DII = DEI − DTIR
- Determine FDDEI.
- Foreign-Derived Deduction Eligible Income (FDDEI) is the income derived from products and services sold to foreign entities for foreign use.
- FDDEI =
- (total gross receipts + gross receipts from partnerships) − (cost of goods sold + cost of goods sold from partnerships)
- − allocable deductions, including deductions from partnerships, interest deductions, research and experimental deductions, and other apportioned deductions.
- Foreign-Derived Ratio (FDR) = FDDEI/DEI.
- FDII = FDR * DII
- GILTI Inclusion = GILTI reported on Form 8992.
- If FDII + GILTI − taxable income > 0
- FDII Reduction = FDII/(FDII+GILTI) * (FDII + GILTI − taxable income)
- GILTI Reduction = FDII Reduction − (FDII + GILTI − taxable income)
- FDII Deduction = (FDII Reduction − FDII) * 37.5%
- GILTI Deduction = (GILTI Inclusion − GILTI Reduction) + Dividends attributable to GILTI * 50%
- Section 250 Deduction = FDII Deduction + GILTI Deduction
- Enter the Section 250 deduction as a special deduction on Schedule C in Form 1120, US Corporation Income Tax Return or other appropriate return.
By arranging their international affairs judiciously, corporations lowered their tax rate substantially. For instance, in 2012, it was reported that Apple paid only 1.9% in corporate taxes on income sourced outside of the US — $713 million in taxes on $36.8 billion of foreign pretax income. If that income had been sourced in the US, then Apple would have had to pay a 35% rate, equal to $12.88 billion, a difference of more than $12 billion! Many large international corporations, such as Facebook, Google, and Starbucks, also paid lower corporate taxes on their foreign income. However, even foreign subsidiaries in European tax havens still pay considerable sums for employment and value-added taxes.
In the United States, corporations had to pay income tax on all earned income regardless of where it was earned, although this system was mitigated by allowing deferrals and credits for taxes paid in other countries. However, multinational corporations have greatly reduced their taxes by taking advantage of many available tax loopholes, especially by locating intellectual property in low-tax foreign jurisdictions, such as Ireland. Moreover, multinational corporations, such as Apple and Google, were holding billions of dollars in offshore accounts to defer the tax on the income; otherwise, they must pay corporate rates as high as 35% on any repatriated income.
Under the tax package passed by the Republicans at the end of 2017, known as the Tax Cuts and Jobs Act, new provisions replaced the worldwide income tax with a modified territorial system in which taxes only have to be paid on domestic profits. Additionally, to promote the repatriation of trillions of dollars held overseas by international businesses, any repatriated cash is taxed at a lower rate of 15.5%, and non-cash funds are taxed at 8%. This new tax rate has promoted repatriation.