CH-24 The U.S. Taxation of Multinational Transactions – McGraw-Hill’s Taxation of Individuals and Business Entities 2021 : Book Guide

Chapter 24 The U.S. Taxation of Multinational Transactions Discussion Questions 1. [LO 1] Distinguish between an outbound transaction and an inbound transaction from a U.S. tax perspective. An outbound transaction occurs when a U.S. person engages in a transaction outside the United States or one that involves a non-U.S. person. An inbound transaction occurs when a non-U.S. person engages in a transaction within the United States or one that involves a U.S. person. 2. [LO 1] What are the major U.S. tax issues that apply to an inbound transaction? The major U.S. tax issues that apply to an inbound transaction involve 1) whether the non-U.S. person has nexus in the United States (is subject to U.S. taxation), 2) whether the income earned by the non-U.S. person is from U.S. sources, 3) the type of U.S. source income earned (income effectively connected with a U.S. trade or business (ECI) or income that is fixed, determinable, annual or periodic (FDAP)), and 4) whether a treaty applies to modify the U.S. taxation of the transaction that otherwise would apply. 3. [LO 1] What are the major U.S. tax issues that apply to an outbound transaction? The major U.S. tax issues that apply to an outbound transaction involve 1) whether the income earned by the U.S. person is from foreign sources, 2) whether the U.S. person incurs a foreign income tax on the income that is eligible for a credit, 3) whether the income is eligible for repatriation with a 100% dividends received deduction, 4) whether the income will be treated as a deemed dividend under subpart F, 5) the type of foreign source income earned (passive category, general category, foreign branch income, or global low-taxed intangible income), and 6) what deductions taken on the U.S. tax return must be allocated and apportioned to foreign source income for foreign tax credit purposes, the foreign-derived intangible income deduction, or the global low-taxed intangible income deduction. 4. [LO 1] How does a residence-based approach to taxing worldwide income differ from a source-based approach to taxing the same income? Under a residence-based approach, a country taxes the worldwide income of the person earning the income. Under a source-based approach, a country taxes only the income earned within its boundaries. 5. [LO 1] Henri is a resident of the United States for U.S. tax purposes and earns $10,000 from an investment in a French company. Will Henri be subject to U.S. tax under a residence-based approach to taxation? A source-based approach? Henri will be subject to U.S. tax on the income under a residence-based approach because he will be taxed on all of his income regardless of source. Henri will not be subject to U.S. tax on the income under a source-based approach because the income is not U.S. source income. 6. [LO 1] What are the two categories of income that can be taxed by the United States when earned by a nonresident? How does the United States tax each category of income? U.S. source income earned by a nonresident is classified as either effectively connected income (ECI) or fixed and determinable, annual or periodic income (FDAP). Income that is effectively connected with a U.S. trade or business is subject to net taxation (that is, gross income minus deductions) at the U.S. graduated tax rates. FDAP income, which is generally passive income such as dividends, interest, rents, or royalties, is subject to a withholding tax regime applied to gross income. 7. [LO 1] Maria is not a citizen of the United States, but she spends 180 days per year in the United States on business-related activities. Under what conditions will Maria be considered a resident of the United States for U.S. tax purposes? Maria will be considered a resident if she meets one of two tests. Maria will be treated as a resident if she possesses a permanent resident visa (green card) at any time during the calendar year. Maria also will be treated as a resident if she meets the substantial presence test, which will be met if she is physically present in the United States for 31 days or more during the current calendar year, and the number of days of physical presence during the current calendar year plus 1/3 times the number of days of physical presence during the first preceding year plus 1/6 times the number of days of physical presence during the second preceding year equals or exceeds 183. Maria does not meet the substantial presence test if she has not been physically present in the United States during the previous two years. She would, however, be considered a resident if she was in the United States during the current year for at least 183 days. 8. [LO 1] Natasha is not a citizen of the United States, but she spends 200 days per year in the United States on business. She does not have a green card. True or False: Natasha will always be considered a resident of the United States for U.S. tax purposes because of her physical presence in the United States. Explain. False. Natasha likely will be treated as a resident because she meets the physical presence test (i.e., she is in the United States more than 182 days in the current year) She could qualify for nonresident status if she meets an exception in the Internal Revenue Code (for example, she is a student) or she qualifies for nonresident status under a treaty between the United States and her country of residence. 9. [LO 1] Why does the United States allow U.S. taxpayers to claim a credit against their precredit U.S. tax for foreign income taxes paid? The United States applies a residual approach to taxing foreign source income earned by U.S. persons not eligible for the 100% dividends received deduction. Under this approach, the U.S. government collects the difference between the U.S. tax that would have been paid if the income had been U.S. source and the foreign tax paid on such income. The United States accomplishes this objective by allowing the U.S. person a credit for the foreign taxes paid. By using this method, the U.S. attempts to fully or at least partially mitigate the double taxation of foreign earned income by the U.S. persons. 10. [LO 1] What role does the foreign tax credit limitation play in U.S. tax policy? The foreign tax credit limitation is designed to limit the credit allowed for foreign income taxes paid or accrued to the amount of U.S. income tax that would have been paid on the income if it was earned in the U.S. 11. [LO 2] Why are the income source rules important to a U.S. citizen or resident? The income source rules can be important to a U.S. citizen or resident for several reasons: 1) to calculate the numerator in the foreign tax credit limitation calculation (foreign source taxable income), 2) to determine if a dividend from a 10%-or-more owned foreign corporation is eligible for a 100% dividends received deduction 3) to determine if export income qualifies for the foreign-derived intangible income deduction, 4) to determine if a U.S. citizen or resident employed outside the United States is eligible to exclude a portion of foreign source earned income from U.S. taxation under §911, 5) to determine if a U.S. citizen or resident who pays U.S.-source FDAP income to a foreign person (for example, interest or dividends) must withhold U.S. taxes on such payments. 12. [LO 2] Why are the income source rules important to a U.S. nonresident? The U.S. source-of-income rules are important to a U.S. nonresident because they limit the scope of U.S. taxation to only the nonresident’s U.S. source income. 13. [LO 2] Carol receives $500 of dividend income from Microsoft, Inc., a U.S. company. True or False: Absent any treaty provisions, Carol will be subject to U.S. tax on the dividend regardless of whether she is a resident or nonresident. Explain. True. Carol will be taxed on all of her income if she is a U.S. resident. If she is a nonresident, she will be taxed only on her U.S. source income. Because Microsoft, Inc. is a U.S. corporation, the dividend will be treated as U.S. source income and will be subject to (withholding) tax if paid to a non-U.S. citizen or resident. 14. [LO 2] Pavel, a citizen and resident of Russia, spent 100 days in the United States working for his employer, Yukos Oil, a Russian corporation. Under what conditions will Pavel be subject to U.S. tax on the portion of his compensation earned while working in the United States? As a nonresident, Pavel will be subject to U.S. tax on the portion of his compensation that is treated as U.S. source income, which is usually determined based on how much time he spends working in the United States. Pavel may be exempt from U.S. tax on the compensation under a treaty provision in the U.S. – Russian Federation income tax treaty. 15. [LO 2] What are the potential U.S. tax benefits from engaging in an export sale? A U.S. person may be able to treat a portion of the gross profit from the sale of inventory manufactured in the United States and sold outside the United States as foreign source if foreign-based production assets contributed to the cost of the sale. The portion treated as foreign source will be added to the numerator of the foreign tax credit limitation, potentially absorbing any excess foreign tax credits from other transactions. An export sale also may qualify for a 37.5% deduction if the income qualifies as foreign-derived intangible income. 16. [LO 2] True or False: A taxpayer will always prefer deducting an expense against U.S. source income and not foreign source income when filing a tax return in the United States. Explain. True. The deduction reduces taxable income in either case. By apportioning the expense to U.S. source income, the taxpayer maximizes the numerator of the foreign tax credit limitation and, by so doing, maximizes the foreign tax credit. A taxpayer may want to create a deduction in a foreign tax jurisdiction if the tax rate is higher than the U.S. rate. 17. [LO 2] Distinguish between allocation and apportionment in sourcing deductions in computing the foreign tax credit limitation. Allocation is the qualitative process of associating a deduction with a specific item or items of gross income for purposes of computing foreign source taxable income. Apportionment is the quantitative process of calculating the amount of a deduction that is associated with a specific item or items of gross income for purposes of computing foreign source taxable income. 18. [LO 2] Distinguish between a definitely related deduction and a not definitely related deduction in the allocation and apportionment of deductions to foreign source taxable income. A definitely related deduction is a deduction that can be directly associated with a particular item of income (for example, machine depreciation with manufacturing gross profit). A deduction not directly associated with a particular item of gross income (for example, medical expenses) is referred to as a not definitely related deduction. 19. [LO 2] Briefly describe the method for apportioning interest expense to foreign source taxable income in the computation of the foreign tax credit limitation. Interest expense is allocated to all gross income based on the assets that generated such income. Interest can be apportioned based on average tax book value or alternative tax book value for the year. 20. [LO 3] What is the primary goal of the United States in negotiating income tax treaties with other countries? The U.S. government negotiates treaties to promote trade between the United States and a treaty partner. An income tax treaty is a bilateral agreement between the United States and another country in which each country agrees to modify its own tax laws to achieve reciprocal benefits. The general purpose of an income tax treaty is to eliminate or reduce the impact of double taxation on cross-border transactions so that residents paying taxes to one country will not have the full burden of taxes in the other country. 21. [LO 3] What is a permanent establishment, and why is it an important part of most income tax treaties? A permanent establishment generally is a fixed place of business such as an office or factory, although employees acting as agents can create a permanent establishment if they can negotiate or sign contracts on behalf of their employer. U.S. (non-U.S.) businesses generally are not taxed on business profits earned in the host treaty country (United States) unless they conduct their business in that country through a permanent establishment. 22. [LO 3] Why is a treaty important to a nonresident investor in U.S. stocks and bonds? A treaty often reduces (or eliminates) the U.S. statutory withholding tax (30 percent) otherwise imposed on U.S. source interest and dividends paid to a nonresident investor. 23. [LO 3] Why is a treaty important to a nonresident worker in the United States? A nonresident worker in the United States generally will be subject to U.S. tax on his or her U.S. source wages. A treaty may exempt such wages from U.S. tax if the worker is in the United States for less than a prescribed number of days or the total wages do not exceed a stated amount. 24. [LO 4] Why does the United States use a “basket” approach in the foreign tax credit limitation computation? The “basket” approach limits foreign tax credit blending opportunities (high-tax foreign source income and low-tax foreign source income) to income that is of the same character. Currently, there are four primary categories of FTC income: passive category income, general category income, foreign branch company income, and global intangible low-taxed income (GILTI). 25. [LO 4] True or False: All dividend income received by a U.S. taxpayer is classified as passive category income for foreign tax credit limitation purposes. Explain. False. Dividends received from a 10%-or-more owned foreign corporation by a U.S. corporation are eligible for the 100% dividends received deduction and are exempt from U.S. taxation. Dividends not eligible for the 100% dividends received deduction are treated as passive category income. 26. [LO 4] True or False: All foreign taxes are creditable for U.S. tax purposes. Explain. False. Only foreign income taxes are creditable for U.S. tax purposes. Other foreign taxes (property, value-added, payroll) can only be deducted in computing taxable income. In addition, foreign taxes associated with dividends eligible for the 100% dividends received deduction are not creditable. Only 80% of foreign income taxes associated with the GILTI deemed dividend are creditable. 27. [LO 5] What is a hybrid entity for U.S. tax purposes? Why is a hybrid entity a popular organizational form for a U.S. company expanding its international operations? What are the potential drawbacks to using a hybrid entity? A hybrid entity is an entity for which an election is available to choose the entity’s tax status for U.S. tax purposes. Hybrid entities such as limited liability companies can provide the U.S. investor with the legal advantages of corporate form (limited liability, continuity of life, transferability of interests) and the tax advantages of partnership or branch form (flow-through of losses and flow-through of foreign taxes to investors). A potential drawback to operating through a hybrid entity in a foreign jurisdiction is the entity may not be eligible for treaty benefits because the host country does not recognize it as a resident of the host country, which is a prerequisite to being eligible for treaty benefits (an example would be the U.S. – Canada income tax treaty). 28. [LO 5] What is a “per se” entity under the check-the-box rules? A “per se” entity is a foreign entity that is not eligible to make a check-the-box election to be treated as a flow-through entity for U.S. tax purposes. These ineligible entities tend to be entities that can be publicly traded in their host countries (for example, a German A.G., Dutch N.V., U.K. PLC, Spanish S.A., and a Canadian Corporation). 29. [LO 6] What are the requirements for a foreign corporation to be a controlled foreign corporation for U.S. tax purposes? A controlled foreign corporation is defined as any foreign corporation in which U.S. shareholders collectively own more than 50 percent of the total combined voting power of all classes of stock entitled to vote or the total value of the corporation’s stock on any day during the foreign corporation’s tax year. For this purpose, a “U.S. shareholder” is any U.S. person who owns or is deemed to own 10 percent or more of all classes of stock entitled to vote. 30. [LO 6] Why does the United States not allow exclusion on all foreign source income earned by a controlled foreign corporation? Exclusion of U.S. taxation on all foreign source income earned through a foreign subsidiary would invite tax planning strategies that shift income to low-tax countries to minimize the taxpayer’s worldwide tax liability. U.S. taxpayers could transfer investment assets to corporations located in low (no) tax countries (tax havens) and avoid U.S. tax on such low-tax or tax-exempt income. 31. [LO 6] True or False: A foreign corporation owned equally by 11 U.S. individuals can never be a controlled foreign corporation? Explain. False. Although each shareholder owns less than 10 percent of the foreign corporation’s stock directly, and thus does not qualify as a U.S. shareholder for CFC purposes, one or more of the shareholders could be deemed to own stock of another shareholder through the stock attribution (constructive ownership) rules. For example, one or more of the shareholders could be members of the same family (parents, children, grandchildren). The constructive ownership rules could cause one or more shareholders to be U.S. shareholders whose collective ownership of stock could exceed 50 percent. 32. [LO 6] What is foreign base company sales income? Why does the United States include this income in its definition of subpart F income? Foreign base company sales income is defined as income derived by a CFC from the sale or purchase of personal property (for example, inventory) to (or from) a related person and the property is manufactured and sold outside the CFC’s country of incorporation. This category of subpart F income was added because many countries offer incentives to multinational corporations to locate holding companies or sales companies within their borders by imposing no or a low tax on investment income or export sales. Without any anti-deferral rules, a U.S. multinational corporation could shift profits to a foreign base company by selling goods to the base company at an artificially low transfer price. The base company could then resell the goods at a higher price to the ultimate customer in a different country. The profit earned by the base company would be subject to the lower (or no) tax imposed by the tax haven country. 33. [LO 6] True or False: Subpart F income is always treated as a deemed dividend to the U.S. shareholders of a controlled foreign corporation. Explain. False. Subpart F income is not treated as a deemed dividend if the total amount falls below a prescribed de minimis amount, which is the lesser of 5 percent of gross income or $1 million. In addition, a U.S. shareholder can elect to exclude “high tax” subpart F income from the deemed dividend rules. High-tax subpart F income is income taxed at an effective tax rate that is 90 percent or more of the highest U.S. statutory rate. For a U.S. corporation, the “high tax” rate currently is 18.9 percent (.90 x .21). 34. [LO 6] What is global intangible low-tax income (GILTI)? How and when is the GILTI of controlled foreign corporations taxed? GILTI is the income (other than subpart F income) of a CFC that exceeds 10 percent of the CFC’s invested foreign assets. In theory, it represents above normal returns from the trade or business income of CFCs. U.S. shareholders of CFCs include their share of GILTI annually in taxable income. U.S. corporate shareholders of CFCSs are eligible for foreign tax credits of up to 80 percent of the foreign taxes paid on their share of GILTI, and they are also allowed a deduction equal to 50 percent of GILTI for tax years prior to 2026. In contrast, U.S. individual shareholders generally are not eligible for foreign tax credits or deductions related to their share of GILTI. 35. [LO 6] True or False: All outbound payments from a U.S. corporation to a related foreign subsidiary are subject to the BEAT minimum tax. Explain. False. Outbound payments that do not exceed three percent of total deductions are not subject to the 10% BEAT minimum tax. In addition, the BEAT only applies to corporations with annual average gross receipts of at least $500 million for the three tax-year periods ending with the preceding tax year. Problems 36. [LO 1] Camille, a citizen and resident of Country A, received a $1,000 dividend from a corporation organized in Country B. Which statement best describes the taxation of this income under the two different approaches to taxing foreign income? a. Country B will not tax this income under a residence-based jurisdiction approach but will tax this income under a source-based jurisdiction approach. b. Country B will tax this income under a residence-based jurisdiction approach but will not tax this income under a source-based jurisdiction approach. c. Country B will tax this income under both a residence-based jurisdiction approach and a source-based jurisdiction approach. d. Country B will not tax this income under either a residence-based jurisdiction approach or a source-based jurisdiction approach. a. Country B will not tax this income under a residence-based jurisdiction approach but will tax this income under a source-based jurisdiction approach. 37. [LO 1] Spartan Corporation, a U.S. corporation, reported $2 million of pretax income from its business operations in Spartania, which were conducted through a foreign branch. Spartania taxes branch income at 15 percent, and the United States taxes corporate income at 21 percent. a. If the United States provided no mechanism for mitigating double taxation, what would be the total tax (U.S. and foreign) on the $2 million of branch profits? b. Assume the United States allows U.S. corporations to exclude foreign source income from U.S. taxation. What would be the total tax on the $2 million of branch profits? c. Assume the United States allows U.S. corporations to claim a deduction for foreign income taxes. What would be the total tax on the $2 million of branch profits? d. Assume the United States allows U.S. corporations to claim a credit for foreign income taxes paid on foreign source income. What would be the total tax on the $2 million of branch profits? What would be your answer if Spartania taxed branch profits at 30 percent? If Spartania taxed branch profits at 30 percent, the United States would allow the foreign tax to reduce the U.S. tax to zero, but the excess $180,000 would become a carryback or carryforward to a prior or future years. 38. [LO 1] Lars is a citizen and resident of Belgium. He has a full-time job in Belgium and has lived there with his family for the past 10 years. In 2018, Lars came to the United States for the first time. The sole purpose of his trip was business. He intended to stay in the United States for only 180 days, but he ended up staying for 210 days because of unforeseen problems with his business. Lars came to the United States again on business in 2019 and stayed for 180 days. In 2020 he came back to the United States on business and stayed for 70 days. Determine if Lars meets the U.S. statutory definition of a resident alien in 2018, 2019, and 2020 under the substantial presence test. 2018: Lars meets the definition of a resident alien under the substantial presence test because he is physically present in the United States for at least 183 days. He cannot use the “closer connection” exception because he is physically present in the United States for 183 days or more. 2019: Lars meets the definition of a resident alien under the substantial presence test. His days of physical presence for 2019 total 250, computed as 180 (2018) + {1/3  210 (2017) = 70}. Because Lars is physically present in the United States for less than 183 days in 2019, he can argue that he has a closer connection to Belgium than to the United States to be exempt from the physical presence test. Lars must show that his tax home (regular place of business) is in Belgium. 2020: Lars does not meet the definition of a resident alien under the substantial presence test. His days of physical presence for 2020 total 165, computed as 70 (2019) + {1/3  180 (2018) = 60} + {1/6  210 (2017) = 35}. 39. [LO 1] {Research} Use the facts in problem 37. If Lars meets the statutory requirements to be considered a resident of both the United States and Belgium, what criteria does the U.S.-Belgium treaty use to “break the tie” and determine Lars’s country of residence? Look at Article 4 of the 2007 U.S.-Belgium income tax treaty, which you can find on the IRS website, www.irs.gov. When an individual is claimed as a resident by two jurisdictions, the individual must consult the “tie breaker rules” under the U.S.-Belgium income tax treaty. Article 4 of the U.S. – Belgium treaty (“Resident”), ¶4, states that where an individual is a resident of both Contracting States, he must look to where he has (in descending order): 1. Permanent home (the place where an individual dwells with his family) 2. Center of vital interests (where his personal and economic relations are closer) 3. Habitual abode 4. Citizenship (national) If none of the above criteria is determinative of an individual’s residence, the issue will be resolved by mutual agreement of the competent authorities of both countries. Because Lars has his permanent home in Belgium, he would be treated as a resident of Belgium for U.S. tax purposes. 40. [LO 1] {Research} How does the U.S.-Belgium treaty define a permanent establishment for determining nexus? Look at Article 5 of the 2007 U.S.-Belgium income tax treaty, which you can find on the IRS website, www.irs.gov. Article 5 defines a permanent establishment as a “fixed place of business through which the business of an enterprise is wholly or partly carried on.” In particular, a permanent establishment includes a place of management, a branch, an office, a factory, a workshop, and a mine, an oil or gas well, a quarry, or any other place of extraction of natural resources. Article 5 excludes the following activities as creating a permanent establishment: a) the use of facilities solely for the purpose of storage, display or delivery of goods or merchandise belonging to the enterprise; b) the maintenance of a stock of goods or merchandise belonging to the enterprise solely for the purpose of stor¬age, display or delivery; c) the maintenance of a stock of goods or merchandise belonging to the enterprise solely for the purpose of processing by another enterprise; d) the maintenance of a fixed place of business solely for the purpose of purchasing goods or merchandise, or of collecting information, for the enterprise; e) the maintenance of a fixed place of business solely for the purpose of carrying on, for the enterprise, any other activity of a preparatory or auxiliary character; and f) the maintenance of a fixed place of business solely for any combination of the activities mentioned in subparagraphs a) through e), provided that the overall activity of the fixed place of business resulting from this combination is of a preparatory or auxiliary character. 41. [LO 1] Mackinac Corporation, a U.S. corporation, reported total taxable income of $5 million. Taxable income included $1.5 million of foreign source taxable income from the company’s branch operations in Canada. All of the branch income is foreign branch income. Mackinac paid Canadian income taxes of $375,000 on its branch income. Compute Mackinac’s allowable foreign tax credit. Mackinac Corporation’s precredit U.S. tax is $1,050,000 ($5,000,000 × 21%). The company’s foreign tax credit limitation is computed as: $1,500,000 / $5,000,000 × $1,050,000 = $315,000. Mackinac’s allowable foreign tax credit is limited to $315,000, creating an “excess credit” of $60,000 ($375,000 - $315,000), which can be carried back one year and carried forward 10 years. 42. [LO 1] Waco Leather, Inc., a U.S. corporation, reported total taxable income of $5 million. Taxable income included 1.5 million of foreign source taxable income from the company’s branch operations in Mexico. All of the branch income is foreign branch income. Waco paid Mexican income taxes of $300,000 on its branch income. Compute Waco’s allowable foreign tax credit. Waco’s precredit U.S. tax is $1,050,000 ($5,000,000 × 21%). The company’s foreign tax credit limitation is computed as: $1,500,000 / $5,000,000 × $1,050,000 = $315,000. Waco’s allowable foreign tax credit is the full $300,000. Waco has an “excess foreign tax credit limitation” of $15,000, which can absorb foreign tax credit carryforwards from prior years. 43. [LO 1] Valley View Inc., a US corporation, formed a wholly owned Mexican corporation to conduct manufacturing and selling operations in Mexico. In its first year of operations, the Mexican corporation reported taxable income of Mex$5,000,000 and paid Mexican income tax of Mex$1,500,000 on its taxable income. In the second year of its operations, the Mexican subsidiary pays a dividend of Mex$2,000,000 to Valley View, Inc. The dividend is subject to a 10% withholding tax (Mex$200,000) under the U.S.–Mexico treaty. Assume the currency translation rate for both years is Mex$1:US$.05. a. Assuming that Valley View Inc.’s Mexican subsidiary does not have any subpart F income or global intangible low-tax income (GILTI), how much taxable income would Valley View, Inc. report in U.S. dollars from its Mexican subsidiary’s first year of operations? Valley View will not report any income from its Mexican subsidiary because it is a corporation rather than a branch and it does not have any subpart F income or GILTI. b. How much of the dividend from the Mexican subsidiary is subject to U.S. taxation, and are any of the Mexican taxes imposed on the income distributed creditable in the U.S.? None of the dividend will be taxed in the U.S. Because Valley View, Inc. owns at least 10% of the Mexican subsidiary, it will be eligible for the 100 percent dividends received deduction (participation exemption) on earnings remitted from a foreign corporation that had not previously been subject to the deemed dividend rules of subpart F. On the other hand, none of the Mexican taxes paid, including the Mexican withholding tax, is creditable in the U.S. c. If Valley View, Inc. only held 5 percent of the Mexican corporation stock, how much of the dividend from the Mexican corporation would be subject to U.S. taxation and would any of the Mexican taxes imposed on the income distributed be creditable in the U.S.? In this situation, Valley View Inc. would be ineligible for the participation exemption and all of the dividend from the Mexican corporation would be included in Valley View’s taxable income in the year the dividend is received. Translated into U.S. dollars, the dividend reported would equal $100,000. Finally, the Mexican withholding tax of $10,000 (translated into U.S. dollars) would be creditable by Valley View, Inc. against its U.S. tax subject to any applicable foreign tax credit limitation. 44. [LO 2] Petoskey Stone, Inc., a U.S. corporation, received the following sources of income during the current year. Identify the source of each item as either U.S. or foreign. a. Interest income from a loan to its German subsidiary. b. Dividend income from Granite Corporation, a U.S. corporation. c. Royalty income from its Irish subsidiary for use of a trademark. d. Rent income from its Canadian subsidiary of a warehouse located in Wisconsin. a. Foreign source (residence of the payer of interest) b. U.S. source (residence of the payer of the dividend) c. Foreign source (where the intangible is used) d. U.S. source (where the property being rented is located) 45. [LO 2] Carmen SanDiego, a U.S. citizen, is employed by General Motors Corporation, a U.S. corporation. On April 1, 2020, GM relocated Carmen to its Brazilian operations for the remainder of 2020. Carmen was paid a salary of $120,000 and was employed on a 5-day week basis. As part of her compensation package for moving to Brazil, Carmen also received a housing allowance of $25,000. Carmen’s salary was earned ratably over the twelve month period. During 2020 Carmen worked 260 days, 195 of which were in Brazil and 65 of which were in Michigan. How much of Carmen’s total compensation is treated as foreign source income for 2020? Why might Carmen want to maximize her foreign source income in 2020? Carmen classifies her wages as being U.S. or foreign source based on her working days within the United States and Brazil. Her foreign source wages will be $90,000, calculated as 195 / 260 × $120,000. The $25,000 housing allowance will be treated as foreign source because it is paid to her while she is working in Brazil. Her total foreign source compensation is $115,000 ($90,000 + $25,000). Carmen has an incentive to maximize her foreign source compensation if (when) she becomes eligible for the foreign earned income exclusion under §911, which is $107,600 in 2020 (prorated for the number of days she is physically present in Brazil). 46. [LO 2] Sam Smith is a citizen and bona fide resident of Great Britain (United Kingdom). During the current year, Sam received the following income: ○ Compensation of $30 million from performing concerts in the United States. ○ Cash dividends of $10,000 from a French corporation’s stock. ○ Interest of $6,000 on a U.S. corporation bond. ○ Interest of $2,000 on a loan made to a U.S. citizen residing in Australia. ○ Gain of $80,000 on the sale of stock in a U.S. corporation. Determine the source (U.S. or foreign) of each item of income Sam received. Income Source Income from concerts U.S. source – based on where the event took place Dividend from French corporation Foreign source – based on residence of the payer Interest on a U.S. corporation bond U.S. source – based on residence of the payer Interest of $2,000 on a loan made to a U.S. citizen residing in Australia Foreign source – based on residence of the payer Gain of $80,000 on the sale of stock in a U.S. corporation Foreign source – based on residence of the seller 47. [LO 2] Spartan Corporation, a U.S. company, manufactures green eyeshades for sale in the United States and Europe. All manufacturing activities take place in Michigan. During the current year, Spartan sold 10,000 green eyeshades to European customers at a price of $10 each. Each eye shade costs $4 to produce. All of Spartan’s production assets are located in the United States. For each independent scenario, determine the source of the gross income from sale of the green eyeshades. a. All of Spartan’s production assets are located in the U.S. Gross profit from the sales is $60,000 (10,000 units  {$10 - $4}). 100 percent of gross profit is sourced to the U.S. based on the location where the production assets are located. b. Half of Spartan’s production assets are located outside the U.S. Gross profit from the sales is $60,000 (10,000 units  {$10 - $4}). Gross profit from the sales is $60,000 (10,000 units  {$10 - $4}). 50 percent of gross profit, or $30,000, is treated as foreign source because half of the production assets are located outside the U.S. 48. [LO 2] {Planning} Falmouth Kettle Company, a U.S. corporation, sells its products in the United States and Europe. During the current year, selling, general, and administrative (SG&A) expenses included: Falmouth had $12,000 of gross sales to U.S. customers and $3,000 of gross sales to European customers. Gross income (sales minus cost of goods sold) from domestic sales was $3,000 and gross profit from foreign sales was $1,000. Apportion Falmouth’s SG&A expenses to foreign source income using the following methods: a. Gross sales. To foreign source income: $3,000/$15,000  $2,000 = $400 To U.S. source income: $12,000/$15,000  $2,000 = $1,600 b. Gross income. To foreign source income: $1,000/$4,000  $2,000 = $500 To U.S. source income: $3,000/$4,000  $2,000 = $1,500 c. If Falmouth wants to maximize its foreign tax credit limitation, which method produces the better outcome? The gross sales method apportions the smaller amount of deductions to the numerator of Falmouth’s foreign tax credit limitation formula. As a result, the foreign tax credit limitation ratio will be greater under the gross sales method, and the company’s foreign tax credit will be higher. 49. [LO 2] {Planning} Owl Vision Corporation (OVC) is a North Carolina corporation engaged in the manufacture and sale of contact lens and other optical equipment. The company handles its export sales through sales branches in Belgium and Singapore. The average tax book value of OVC’s assets for the year was $200 million, of which $160 million generated U.S. source income and $40 million generated foreign source income. OVC’s total interest expense was $20 million. a. What amount of the interest expense will be apportioned to foreign source income under the tax book value method? Apportionment using tax book value Tax book value of U.S. assets = $160 million Tax book value of foreign assets = $40 million Interest apportioned to U.S. source income: $160,000,000/$200,000,000  $20 million = $16 million Interest apportioned to foreign source income: $40,000,000/$200,000,000  $20 million = $4 million 50. [LO 3] {Research} Colleen is a citizen and bona fide resident of Ireland. During the current year, she received the following income: • Cash dividends of $2,000 from a U.S. corporation stock. • Interest of $1,000 on a U.S. corporation bond. • Royalty of $100,000 from a U.S. corporation for use of a patent she developed. • Rent of $3,000 from U.S. individuals renting her cottage in Maine. Identify the U.S. withholding tax rate on the payment of each item of income under the U.S.-Ireland income tax treaty and cite the appropriate treaty article. You can access the 1997 U.S.-Ireland income tax treaty on the IRS website, www.irs.gov. Income Withholding Tax Rate Treaty Article Cash dividends of $2,000 15% Article 10, ¶2(b) Interest of $1,000 0% Article 11, ¶1 Royalty of $100,000 0% Article 12, ¶1 Rent of $3,000 30% (U.S. statutory rate) Article 6, ¶1 51. [LO 4] Gameco, a U.S. corporation, operates gambling machines in the United States and abroad. Gameco conducts its operations in Europe through a Dutch B.V., which is treated as a branch for U.S. tax purposes. Gameco also licenses game machines to an unrelated company in Japan. During the current year, Gameco paid the following foreign taxes, translated into U.S. dollars at the appropriate exchange rate: Foreign Taxes Amount (in $) National income taxes 1,000,000 City (Amsterdam) income taxes 100,000 Value-added tax 150,000 Payroll tax (employer’s share of social insurance contributions) 400,000 Withholding tax on royalties received from Japan 50,000 Identify Gameco’s creditable foreign taxes. Gameco’s creditable foreign taxes are those taxes that qualify as income taxes or taxes paid in lieu of income taxes. The creditable income taxes are the national income taxes and the city of Amsterdam income taxes. The withholding tax is creditable because it is imposed “in lieu” of an income tax. Therefore, the total creditable foreign taxes are $1,150,000 ($1,000,000 + $100,000 + $50,000). 52. [LO 4] {Planning} Sombrero Corporation, a U.S. corporation, operates through a branch in Espania. Management projects that the company’s pretax income in the next taxable year will be $100,000, $80,000 from U.S. operations and $20,000 from the Espania branch. Espania taxes corporate income at a rate of 30 percent. a. If management’s projections are accurate, what will be Sombrero’s excess foreign tax credit in the next taxable year? Assume all of the income is foreign branch income. b. Management plans to establish a second branch in Italia. Italia taxes corporate income at a rate of 10 percent. What amount of income will the branch in Italia have to generate to eliminate the excess credit generated by the branch in Espania? Each dollar of foreign taxable income earned in Italia generates an excess FTC limitation of $0.11 [$1  (21% – 10%)]. Sombrero must generate enough low-tax general category foreign source taxable income to eliminate the $1,800 excess credit. The excess credit will be eliminated if Sombrero can generate $16,364 of income in Italia ($1,800/.11). 53. [LO 4] Chapeau Company, a U.S. corporation, operates through a branch in Champagnia. The source rules used by Champagnia are identical to those used by the United States. For 2020, Chapeau has $2,000 of gross income, $1,200 from U.S. sources and $800 from sources within Champagnia. The $1,200 of U.S. source income and $700 of the foreign source income are attributable to manufacturing activities in Champagnia (foreign branch income). The remaining $100 of foreign source income is passive category interest income. Chapeau had $500 of expenses other than taxes, all of which are allocated directly to manufacturing income ($200 of which is apportioned to foreign sources). Chapeau paid $150 of income taxes to Champagnia on its manufacturing income. The interest income was subject to a 10 percent withholding tax of $10. Compute Chapeau’s allowable foreign tax credit in 2020. 54. [LO 5] {Research} Identify the “per se” companies for which a check-the-box election cannot be made for U.S. tax purposes in the countries listed below. Consult the Instructions to Form 8832, which can be found on the “Forms & Instructions” site on the IRS website, www.irs.gov. a. Japan b. Germany c. Netherlands d. United Kingdom e. People’s Republic of China a. Kabushiki Kaisha b. Aktiengesellschaft c. Naamloze Vennootschap d. Public Limited Company e. Gufen Youxian Gongsi 55. [LO 5] {Research} Eagle Inc., a U.S. corporation intends to create a Limitada (limited liability company) in Brazil in 2020 to manufacture pitching machines. The company expects the operation to generate losses of US$2,500,000 during its first three years of operations. Eagle would like the losses to flow-through to its U.S. tax return and offset its U.S. profits. a. Can Eagle “check-the-box” and treat the Limitada as a disregarded entity (branch) for U.S. tax purposes? Consult the Instructions to Form 8832, which can be found on the “Forms & Instructions” site on the IRS website, www.irs.gov. Yes. A Limitada is eligible for a check-the-box election (a Sociedad Anonima is not). b. Assume management’s projections were accurate and Eagle deducted $75,000 of branch losses on its U.S. tax return from 2020-2022. At 01/01/23, the fair market value of the Limitada’s net assets exceeded Eagle’s tax basis in the assets by US$5 million. What are the U.S. tax consequences of “checking-the-box” on Form 8832 and converting the Limitada to a corporation for U.S. tax purposes? Eagle will be treated as transferring the branch assets and liabilities to a foreign corporation in return for stock. Eagle will recognize gain on the transfer of tainted assets and intangibles, and the branch loss recapture rules also will apply. Eagle will recognize gain of at least $5 million, the lesser of the branch loss deduction or the appreciation of the assets transferred. 56. [LO 6] Identify whether the corporations described below are controlled foreign corporations. a. Shetland PLC, a UK corporation, has two classes of stock outstanding, 75 shares of class AA stock and 25 shares of class A stock. Each class of stock has equal voting power and value. Angus owns 35 shares of class AA stock and 20 shares of class A stock. Angus is a U.S. citizen who resides in England. Yes. Angus is a “U.S. shareholder” because he owns 10 percent-or-more of the total combined voting power or value of Shetland PLC assuming each share of stock has the same voting power and value: 35/75 Class AA stock = 46.6%  75/100 = 35% total voting power and value 20/25 Class A stock = 80%  25/100 = 20% total voting power and value Combined voting power and value= 55% Shetland PLC is a CFC because the U.S. shareholder (Angus) owns more than 50 percent of the total voting power or value of its stock. Angus would be required to include in his income currently 55 percent of the corporation’s subpart F income. b. Tony and Gina, both U.S. citizens, own 5 percent and 10 percent, respectively, of the voting stock and value of DaVinci S.A., an Italian corporation. Tony and Gina are also equal partners in Roma Corporation, an Italian corporation that owns 50 percent of the DaVinci stock. Yes. Tony and Gina are U.S. shareholders because they each meet the 10 percent of voting power and value test: Tony and Gina each own their pro rata share of the DaVinci stock owned by the Roma Corporation under §958(b). DaVinci S.A. is a CFC because the U.S. shareholders collectively own more than 50 percent of the value or voting power of its stock. Tony includes 30% of DaVinci’s subpart F income in income currently, and Gina includes 35% of DaVinci’s subpart F income. c. Pierre, a U.S. citizen, owns 45 of the 100 shares outstanding in Vino S.A., a French corporation. Pierre’s father, Pepe, owns 8 shares in Vino. Pepe also is a U.S. citizen. The remaining 47 shares are owned by non-U.S. individuals. Yes. Pierre and Pepe meet the test to be U.S. shareholders: Pierre is deemed to own the shares owned by his parent under the constructive ownership rules of §958(b). Pepe is deemed to own the shares owned by his son under the constructive ownership rules of §958(b). The corporation is a CFC because the ownership of Pierre or Pepe is greater than 50 percent of voting power or value. Pierre includes in his income currently 45 percent of Vino’s subpart F income. Pepe includes in his income currently 8 percent of Vino’s subpart F income. (The constructive ownership rules only apply to determine if the corporation is a CFC and a U.S. person is a U.S. shareholder). 57. [LO 6] USCo owns 100 percent of the following corporations: Dutch N.V., Germany A.G., Australia PLC, Japan Corporation, and Brazil S.A. During the year, the following transactions took place. Determine whether the above transactions result in subpart F income to USCo. a. Germany A.G. owns an office building that it leases to unrelated persons. Germany A.G. engaged an independent managing agent to manage and maintain the office building and performs no activities with respect to the property. No. Rental income received from unrelated persons is not FPHC income if it is derived in the active conduct of a trade or business. Rents are considered derived in the active conduct of a trade or business if the CFC regularly performs active and substantial management and operational functions during the lease period. This rental income would not be FPHC income. b. Dutch N.V. leased office machines to unrelated persons. Dutch N.V. performed only incidental activities and incurred nominal expenses in leasing and servicing the machines. Dutch N.V. is not engaged in the manufacture or production of the machines and does not add substantial value to the machines. Yes. Dutch N.V. would not be engaged in an active trade or business because the CFC did not add substantial value to the machines. The rental income would be foreign personal holding company income. c. Dutch N.V. purchased goods manufactured in France from an unrelated contract manufacturer and sold them to Germany A.G. for consumption in Germany. Yes. The income from sales to German A.G. would be foreign base company sales income because the goods were purchased from an unrelated person outside the CFC’s country of incorporation and sold to a related person for consumption outside the CFC’s country of incorporation. d. Australia PLC purchased goods manufactured in Australia from an unrelated person and sold them to Japan Corporation for use in Japan. No. The income from sales to Japan Corporation would not be foreign base company sales income because the goods were manufactured in the CFC’s country of incorporation. 58. [LO 6] USCo manufactures and markets electrical components. USCo operates outside the United States through a number of CFCs, each of which is organized in a different country. These CFCs derived the following income for the current year. Determine the amount of income that USCo must report as a deemed dividend under subpart F in each scenario. a. F1 has gross income of $5 million, including $200,000 of foreign personal holding company interest and $4.8 million of gross income from the sale of inventory that F1 manufactured at a factory located within its home country. The gross income from sale of inventory is not foreign base company sales income because it was produced in the CFC’s country of incorporation. The $200,000 of interest income is FPHC income. Under the de minimis rule of §954(b)(3)(A), the interest income is not treated as subpart F income if it is (1) less than $1 million and (2) less than 5 percent of gross income. The interest is less than $1 million and is less than 5 percent of gross income ($200,000/$5,000,000 = 4%). The interest income is not treated as subpart F income in this case. b. F2 has gross income of $5 million, including $4 million of foreign personal holding company interest and $1 million of gross income from the sale of inventory that F2 manufactured at a factory located within its home country. The interest income is foreign personal holding company income. The gross income from sale of inventory is not foreign base company sales income because F2 produced the inventory in its country of incorporation. Under the full inclusion rule of §954(b)(3)(B), all gross income is subpart F income if gross subpart F income is more than 70 percent of total gross income. F2’s subpart F income ($4 million) is 80 percent of total gross income. Therefore, F2’s entire gross income ($5 million) is subpart F income. Comprehensive Problems 59. Spartan Corporation manufactures quidgets at its plant in Sparta, Michigan. Spartan sells its quidgets to customers in the United States, Canada, England, and Australia. Spartan markets its products in Canada and England through branches in Toronto and London, respectively. Spartan reported total gross income on U.S. sales of $15,000,000 and total gross income on Canadian and U.K. sales of $5,000,000, split equally between the two countries. Spartan paid Canadian income taxes of $600,000 on its branch profits in Canada and U.K. income taxes of $700,000 on its branch profits in the U.K. Spartan financed its Canadian operations through a $10 million capital contribution, which Spartan financed through a loan from Bank of America. During the current year, Spartan paid $600,000 in interest on the loan. Spartan sells its quidgets to Australian customers through its wholly owned Australian subsidiary. Spartan reported gross income of $3,000,000 on sales to its subsidiary during the year. The subsidiary paid Spartan a dividend of $670,000 on December 31 (the withholding tax is 0 percent under the U.S.-Australia treaty). Spartan paid Australian income taxes of $330,000 on the income repatriated as a dividend. a. Compute Spartan’s foreign source gross income and foreign tax (direct and withholding) for the current year. b. Assume 20 percent of the interest paid to Bank of America is allocated to the numerator of Spartan’s FTC limitation calculation. Compute Spartan Corporation’s FTC limitation using your calculation from part (a) and any excess FTC or excess FTC limitation (all of the foreign source income is put in the foreign branch FTC basket). 60. Windmill Corporation manufactures products in its plants in Iowa, Canada, Ireland, and Australia. Windmill conducts its operations in Canada through a 50 percent owned joint venture, CanCo. CanCo is treated as a corporation for U.S. and Canadian tax purposes. An unrelated Canadian investor owns the remaining 50 percent. Windmill conducts its operations in Ireland through a wholly owned subsidiary, IrishCo. IrishCo is a controlled foreign corporation for U.S. tax purposes. Windmill conducts its operations in Australia through a wholly owned hybrid entity (KiwiCo) treated as a branch for U.S. tax purposes and a corporation for Australian tax purposes. Windmill also owns a 5 percent interest in a Dutch corporation (TulipCo). During 2020, Windmill reported the following foreign source income from its international operations and investments. CanCo IrishCo KiwiCo TulipCo Dividend income Amount $45,000 $28,000 $20,000 Withholding tax 2,250 1,400 3,000 Interest income Amount $30,000 Withholding tax 0 0 Branch income Taxable income $93,000 AUS income taxes $31,000 Notes to the table 1. CanCo and KiwiCo derive all of their earnings from active business operations. a. Classify the income received by Windmill into the appropriate FTC baskets. b. Windmill has $1,250,000 of U.S. source gross income. Windmill also incurred SG&A of $300,000 that is apportioned between U.S. and foreign source income based on the gross income in each basket. Assume KiwiCo’s gross income is $93,000. Compute the FTC limitation for each basket of foreign source income. 61. {Tax Forms} Euro Corporation, a U.S. corporation, operates through a branch in Germany. During 2020, the branch reported taxable income of $1,000,000 and paid German income taxes of $300,000. In addition, Euro received $50,000 of dividends from its 5% investment in the stock of Maple Leaf Company, a Canadian corporation. The dividend was subject to a withholding tax of $5,000. Euro reported U.S. taxable income from its manufacturing operations of $950,000. Total taxable income was $2,000,000. Pre-credit U.S. taxes on the taxable income were $420,000. Included in the computation of Euro’s taxable income were “definitely allocable” expenses of $500,000, 50 percent of which were related to the German branch taxable income. Complete pages 1 and 2 of Form 1118 for just the foreign branch income reported by Euro. You can use the “fill-in” form available on the IRS website, www.irs.gov. 62. {Research} USCo, a U.S. corporation, has decided to set up a headquarters subsidiary in Europe. Management has narrowed its location choice to either Spain, Ireland, or Switzerland. The company has asked you to research some of the income tax implications of setting up a corporation in these three countries. In particular, management wants to know what tax rate will be imposed on corporate income earned in the country and the withholding rates applied to interest, dividends, and royalty payments from the subsidiary to USCo. To answer the tax rate question, consult KPMG’s Corporate and Indirect Tax Survey 2019, which you can access at https://home.kpmg.com/xx/en/home/services/tax/tax-tools-and-resources/tax-rates-online/corporate-tax-rates-table.html. To answer the withholding tax questions, consult the treaties between the United States and Spain, Ireland, and Switzerland, which you can access at www.irs.gov (type in “treaties” as your search word). Solution Manual for McGraw-Hill's Taxation of Individuals and Business Entities 2021 Brian C. Spilker, Benjamin C. Ayers, John A. Barrick, Troy Lewis, John Robinson, Connie Weaver, Ronald G. Worsham 9781260247138, 9781260432534