International Overview Training:

Post 2017 Tax Reform

Topic I
U.S. Tax Regime
and International Matrix:
Pre Tax Cuts & Jobs Act (TCJA)
 IRS Front Matter Items

 The IRS Mission Statement

 14 General Principles of Ethical Conduct for

Federal Employees

 Your Rights as a Taxpayer

2
 Learning Objectives

At the end of this lesson you will be able to:

A. Describe the basics of U.S international tax
(pre-TCJA)

B. Describe the differences between inbound and

outbound transactions

C. Explain the organization and content of the

International Matrix (pre-TCJA)

3
A. Basics of U.S. International
Tax (Pre-TCJA)
 Tax Systems Overview
 In a worldwide system of taxation, a jurisdiction
imposes tax on its residents on all income earned
both at home or abroad. Double taxation is mitigated
by foreign tax credits (FTCs). Taxpayers may pay
residual tax on foreign income if the foreign tax rate is
less than the domestic tax rate.

 In a territorial system of taxation, a jurisdiction

imposes tax only on income earned at home. The
hallmark of territoriality is a participation exemption, or
dividends received deduction (DRD), for foreign
dividends. No domestic tax on foreign income.

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 Tax Systems Overview (Cont’d)
 Most jurisdictions have a hybrid system with
components of both worldwide and territorial systems.
 In a hybrid system, some foreign income may be
currently taxed, some foreign income may be tax-
deferred, and some may be tax-exempt.
 The U.S. Pre-TCJA system is a hybrid system.
 The U.S. taxation of international transactions is
divided into “outbound” and “inbound.”

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 Global Tax Organizational Chart

 The Global tax organizational chart (GTOC):

• Is a visual/graphical representation of the taxpayer's
global entities and reflects the entities’ relationships

• Consists of a series of shapes connected by lines

which depict the ownership structure of the related
entities

7
 Entity Symbols
Below are commonly used symbols that you may
encounter outside of IRS:

Corporation Reverse Hybrid Corporation

(US corporation, foreign pass-through)

Partnership Hybrid Partnership

(US pass-through, foreign corporation)

Branch, DE or Hybrid Branch or Disregarded Entity

Individual “DE”
(US branch or DE, foreign
corporation)

Trust

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“Inbound” and “Outbound” Entities

Inbound: Foreign Persons Outbound: U.S. Persons

Investing in the U.S. Investing Overseas

Foreign U.S.
Corp Corporation

U.S.
U.S. Branch, Foreign Branch, Foreign
Corporation Activity, or Activity, or
Pass-through
Corp
Pass-through

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B-1. Business Outbound Taxation
 Outbound Overview

 Outbound focuses on U.S. persons with foreign

activities or investments.
 U.S. persons are subject to tax on all income earned
at home or abroad.
• Except: Deferral of income earned by foreign subsidiary,
subject to anti-deferral rules (e.g., Subpart F).
• Double taxation is mitigated by foreign tax credits (FTCs).

 Other outbound areas of concern.

• Shifting of income and/or income producing property.
• Repatriation with minimal U.S. tax.

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 Business Outbound Illustration

U.S. Parent

Foreign Foreign U.S.

Foreign U.S. Sub
Branch Corp Branch
P-ship

• Current foreign 12.5% Current U.S.

tax 35% tax
• U.S. tax deferred until
• Current foreign 12.5% tax distribution (except for
• Current U.S. 35% tax anti-deferral rules)
(less FTC for foreign tax)
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 Income Shifting Outbound

 U.S. multinational enterprises (MNEs) may own one

or more foreign entities (“related parties”).
 When two related parties transact business with each
other, the possibility exists that the price paid may be
affected by the related party status, and differences
from the prices that would be negotiated at arm’s
length between unrelated parties could be motivated
by differences in domestic and foreign tax rates.

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Income Shifting Outbound (Cont’d)
 For example, a U.S. taxpayer may shift valuable
Intangible Property (IP) to its controlled foreign
subsidiary.
 The U.S. taxpayer should be compensated for the use or
transfer of the IP by the controlled foreign subsidiary.
 The U.S. taxpayer may inappropriately underprice the
royalty, which decreases U.S. earnings and increases
foreign earnings.
 Such pricing disparity could result in a U.S. taxpayer
underreporting its future U.S. taxable income, and
consequently, its federal income taxes.

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Income Shifting Outbound: Illustration

U.S.
License of License
Intangible Payment
Property Foreign Corporation (Royalty)
(Country X
Low-tax rate)

15
 Income Shifting Outbound: Arm’s
Length Standard
 Income shifting is not unlawful in and of itself, if the
related parties reach an arm’s length price, then the
resulting income shifting is permissible.
 The transfer pricing IRC and regulations provide that
the pricing for transactions between controlled parties
must meet the arm’s length standard, which is met if
the results are consistent with those that would have
been realized between uncontrolled parties under the
same or similar circumstances.

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 Outbound - Deferral Planning

 After shifting income to one or more CFCs in low-tax

jurisdictions to achieve a low ETR, under a worldwide
tax with deferral system, U.S. MNEs may have
incentives to defer current U.S. taxation of the CFCs’
earnings for as long as possible.
 Recall, income earned indirectly through a CFC is not
taxed until profits are repatriated (unless caught by
one of the anti-deferral rules).
 Thus, U.S. MNEs are incentivized to structure and
plan to avoid triggering anti-deferral rules.

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 Outbound Anti-Deferral Rules

 Main Anti-Deferral Regimes:

• Subpart F income:
− Passive income (dividends, interest, rent, royalties and
annuities)
− Related party sales and services income
− Many exceptions and opportunities for deferral planning
• Investments in U.S. Property
− Targeted at acts that bring earnings back to U.S. without a
“dividend”. E.g., loans to U.S. related party.
• Passive Foreign Investment Company (“PFIC”)
− >75% of gross income passive or > 50% assets produce passive
or no income

 Consequence: Current U.S. tax, potentially reduced by

FTCs.
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Outbound Anti-Deferral Rules (Cont’d)

 The Subpart F and investment in U.S. property anti-

deferral rules apply to a “U.S. shareholder” who
owns stock in a “Controlled Foreign Corporation”
(CFC).
 CFC: >50% (vote or value) owned by U.S.
Shareholders
 U.S. Shareholder: U.S. person who owns 10% or
more of voting power
 U.S. Shareholder required to file Form 5471

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 Example 1:
Deferral Planning Outbound - Subpart F

Subpart F Example 1:
USP U.S. Parent (USP) is
subject to current tax on
its pro rata share of
CFC’s subpart F income.
CFC
Country X

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 Example 2:
Deferral Planning Outbound - Subpart F

U.S.P Subpart F Example 2:

CFC’s income from the
Sale to USP sale of widgets is
Foreign Base Company
CFC Sales Income.
Country X

Sale from
unrelated
vendor

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 Example 3:
Deferral Planning Outbound - Inv in US Prop

Investment of
earnings in U.S.
U.S.P
property Example 3

$100x Loan
CFC’s loan to U.S.P
is included in U.S.P’s
income currently.
CFC

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 Foreign Tax Credit (FTC) Basics

 U.S. taxpayers (by citizenship or place of

incorporation) pay U.S. tax on worldwide income, but
may also pay foreign tax where the income is earned
(source country) or where the taxpayer is doing
business or has a subsidiary (residence country)
 FTC alleviates double taxation on foreign source
income to neutralize the effect of tax considerations on
investment location
 Foreign tax paid must be an income tax, and must be
compulsory.

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Intro to Outbound: Foreign Tax Credit

USP USP

Dividend,
100% 20% e.g., $8 + $2 gross-up
under §78

Foreign
Branch CFC

• $100 active business income • $100 active business income

• $20 Foreign tax • $20 Foreign tax
• $80 Earnings and Profits

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 Intro to Outbound: FTC

Shareholders
CFC:
• Current U.S. tax at
USP: 35% rate on
Current U.S. tax at 35% rate on “subpart F
income earned at U.S.P level, USP income,”
potentially reduced by FTCs potentially reduced
(limited by baskets) by FTCs (limited
by baskets)

• Income increased
USP/Branch: Foreign by gross-up for
Current U.S. tax at CFC foreign taxes
35% rate on income Branch
deemed paid
earned at foreign
branch level, • U.S. tax at 35% on
potentially reduced by dividend with
FTCs (limited by respect to residual
baskets) foreign earnings

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 Foreign Tax Credit (FTC)

Section 904 limits effectuate FTC goals:

 Section 904 limits FTCs to U.S. tax on foreign-source
income. No credit for foreign tax paid on U.S. source
income.
• Goal: U.S. has primary right to tax U.S. source income.

 Section 904(d) further limits FTCs by certain categories

(“baskets”) of income.
• Goal: Prevent crediting excess foreign taxes paid on high-tax
income of one type (e.g. high-taxed manufacturing income)
against U.S. tax on lower-taxed income of another type (e.g.,
low-taxed interest income).

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 FTC Basket Limitation Equation

 §904(d) limits the FTC to the pre-credit U.S. tax on a

specific type of foreign-source taxable income
(“FSTI”):
FSTI in 904(d) Basket x Pre-credit U.S. Tax
World-wide taxable income

 Or: FSTI in each basket x U.S. tax rate

 Because FSTI is on a net basis, expense allocation
(domestic vs. foreign and basket-by-basket) is key

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 FTC Basics – Expense Allocation

 U.S.-based MNEs may seek to maximize foreign tax

credits and reduce their ETR through expense
allocation to income.
 Interest expense is considered to relate to all income,
and must be apportioned to each category based on
the relative value (or tax basis) of the assets that
produce income in that category.

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 Outbound - Repatriation

 Once a U.S. MNE has lowered its ETR by shifting

income to a lower-tax CFCs, the taxpayer may want
to repatriate the cash accumulated back to the U.S.
without incurring a residual U.S. tax (35% less
available credits) on the repatriated earnings.

 Repatriation
• Actual distributions – cash may be subject to current U.S. tax
• “Investment in U.S. property” such as CFC loans to U.S.
affiliates, CFC purchases of tangible property located in the
U.S. or stock issued by a related domestic corporation are
subject to current U.S. tax like taxable distributions.

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 Basic Distribution Rules
Example: Taxable Dividend Distribution

U.S.P.
$200 basis in CFC-1
$100

CFC-1 $100 E&P

$100 Cash

 Basic Rules for corporate distributions:

1st - § 301(c)(1) – Dividend to the extent of Earnings & Profits (E&P) (taxable);
2nd - § 301(c)(2) – Return of basis to the extent thereof (non-taxable); and
3rd - § 301(c)(3) – Gain from the sale or exchange of property (taxable).

 Note – because CFC-1 has $100 E&P, the $100 distribution

is a taxable dividend distribution under section 301(c)(1).

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 Basic Distribution Rules
Example: Tax Free Return of Basis

U.S.P.
$200 basis in CFC-1
$100

CFC-1 $0 E&P
$100 Cash

 Basic Rules for corporate distributions:

1st - § 301(c)(1) – Dividend to the extent of E&P (taxable);
2nd - § 301(c)(2) – Return of basis to the extent thereof (non-taxable); and
3rd - § 301(c)(3) – Gain from the sale or exchange of property (taxable).

 Note that because CFC-1 has no E&P, the $100

distribution is a non-taxable return of basis under section
301(c)(2)
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 Repatriation: Investment
in U.S. property
Investment in U.S.
Property Example
• U.S. Parent (U.S.P)
U.S.P corporation wholly owns
CFC. CFC makes a loan
$100x Dividend distribution of $100x.
Or $100x Loan • Loan as a disguised
repatriation
CFC
• Included in U.S.P’s current
income and subject to U.S.
tax

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B-2. Business Inbound Taxation
Business Inbound Taxation (pre-TCJA)

 Business Inbound focuses on foreign-based MNE with

U.S. activities or U.S. investments.

Foreign
Parent

U.S. Foreign Foreign

U.S. Sub U.S.
Branch DE Sub
P-ship

Potential U.S. tax exposure

through these entities’ operations
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 Inbound Overview

 Foreign Persons are subject to U.S. tax on:

• Gross U.S.-source fixed, determinable, annual, or periodic
income (“FDAP”) via 30% withholding tax.
− U.S.-source dividends, interest, rents, royalties, etc.
• The amount of income that is effectively connected with a
U.S. trade or business , net of allocable deductions,
(“effectively connected income“ or “ECI“ of a “USTB”) is
taxable at graduated rates.
• Non-FDAP & non-ECI, even if U.S.-source, is NOT taxed.

 Treaty may reduce withholding rates on FDAP and

limit taxable ECI to income that is attributable to a
permanent establishment (PE) in the U.S.

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 Inbound - Jurisdiction to Tax

 Foreign MNEs are generally subject to tax only on

U.S.-source FDAP or the net amount of income that
is effectively connected with a USTB.
 Therefore, sourcing of income (as U.S. vs. foreign) is
crucial for Inbound taxpayers.
 Tax treaties among jurisdictions also assign taxing
rights amongst countries. Therefore, treaties play an
enhanced role in the inbound regime.

36
 Source in a Nutshell
 Where are the types of income being recognized and
taxed:
• Interest, Dividends: generally, residence of payor
• Personal services: place of performance
• Rents and royalties:
− Tangible Property: location of property
− Intangible Property: location of protection
• Gain on sales of real property: location of real property
• Gain on sales of personal property:
− Default: location of seller
− Purchased Inventory: passage of title
− Manufactured Inventory: generally split
− Depreciable personal property: U.S.-source up to depreciation taken
− Contingent comp for intangible personal property: follow royalty rule
• Space/ocean income: place of residence of performer
• Insurance income: location of insured
• Special rules for sales through offices / fixed places
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 Illustration: U.S. Source FDAP
Example 1: FDAP
• U.S.-Source FDAP subject to
e.g., rents, 30% withholding tax on gross
Corporation royalties Unrelated amount.
(Country X) U.S. Corp
• FDAP includes U.S.-source:
− Dividends
e.g., dividends, interest − Interest, OID
− Rents, royalties
− Comp. for personal services
U.S. Sub − Commissions
− Pensions, annuities
− Alimony
− Scholarships, grants, prizes
Example 2: ECI − And more…
e.g., comp. • FDAP does not include ECI.
for U.S. − Usually good for taxpayers,
services,
Country X Unrelated because FDAP is 30% gross
Resident U.S. Corp withholding, ECI is taxed on net.
− Taxpayer must claim ECI
exemption, else withheld at
30%.
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Inbound - Jurisdiction to Tax (Cont’d)
 If foreign MNE has a U.S.-based Foreign Controlled
Corporation (FCC*) as a subsidiary, the FCC is taxed like a
U.S. Corporation and files a Form 1120 return
 If foreign MNE engages in activities in the U.S. through a
branch or partnership, the foreign MNE must file Form
1120-F if:
• Engaged in a U.S. trade or business and had income effectively
connected with a U.S. trade or business, or
• Had any other U.S. FDAP (interest, dividends, royalties, etc.) that is
not effectively connected with a U.S. trade or business and for which
tax was not properly withheld
 As the nature of activities by the FCC increases, the foreign
MNE may become subject to U.S. taxation.
• U.S. trade or business threshold (IRC based)
• Permanent Establishment threshold(Treaty based)
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 Inbound - Jurisdiction to Tax:
U.S. Trade or Bus/Perm Establishment
 USTB
• Under the IRC, an FC engaged in a “U.S. trade or business”
(through a branch or partnership) is taxed on its ECI.
• It may also be subjected to the “branch profits tax.”
• If it is a partnership, U.S. withholding tax may be required.

 PE
• If a tax treaty applies between the countries, these rules are a
little different.
• Tax treaties serve to establish who has primary jurisdiction to
tax the income.
• Tax treaties also specify how certain income types will be
taxed and at what rates.

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Illustration: Income Effectively Connected
to U.S. Trade or Business
Example 1: USTB with ECI • ECI: Net income tax, normal
rates
Corporation Unrelated • Step 1: USTB?
− Is the U.S. activity considerable,
(Country X) U.S. Corp
e.g., continuous, and regular so as to
royalties, $ rise to the level of a USTB?
for tangible − No fixed location required.
Regular U.S. goods • Step 2: Determine source
activities (no
• Step 3: Effectively
fixed
location)
connected?
− If there’s a USTB, most U.S.­
source income is ECI. No
Example 2: USTB with ECI factual connection required.
− Certain foreign-source income
may be ECI
Country X Unrelated − Comp. for personal services
Resident e.g., comp. U.S. Corp performed in U.S. is generally
ECI.
for services − Investment income (e.g.
performed dividends, interest, gains)
in U.S. requires a factual connection to
assets or activities of USTB.
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Illustration: Income Attributable to PE
 Permanent Establishment:
Example 1: Treaty exempts payments • Fixed place through which
that are otherwise ECI from U.S. tax business is carried on
• Places of management
• Factories
Corporation Unrelated • Offices
(Country Y) U.S. Corp • Long-term construction sites
e.g., sales
income
• Income attributable to
activities of dependent agents
• Need not be owned or leased
Regular U.S.
if regularly available to
activities (no
fixed taxpayer
location)
 Attributable to:
• Net income economically
generated by the activities of the
PE.

• Treaty may also reduce

withholding on non­
business income.
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 Inbound - Income Shifting

 Income shifting inbound, similar to the Outbound Face,

occurs when a foreign MNE and its FCC, U.S. Branch
or U.S. Partnership shift income and/or expenses
amongst themselves.
 Inbound income shifting is subjected to the arm’s
length standard and requires consideration of the
same factors as the Outbound Face.

43
Income Shifting Inbound

Inbound Transfer Pricing

Services Example
FP • FP wholly owns U.S. Sub
• FP is in a low tax jurisdiction.
Services • U.S. Sub is providing Research
$
& Development services to FP.
• U.S. Sub includes FP payments
U.S. Sub
in income.
• Incentive to understate the
services value.

44
 Inbound Financing

 Inbound financing is a decision by a foreign MNE to

invest in the U.S. through a variety of financing
arrangements designed to minimize U.S. taxable
income
 One of the most common goals from these
arrangements is to generate U.S. deductions (usually
interest deductions) that result in low tax or no tax to
the foreign related party receiving the payment.
 Foreign MNEs had flexibility in how they set up these
financing structures:
• Debt
• Equity
• Hybrid Structures (Instruments/Entities)
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 Inbound Financing
Example:
 Debt/equity standards are
based on facts and
FP circumstances developed
Dividend income through case law.
 FP could decrease U.S. tax
liabilities through:
Preferred • Deduction of interest.
Interest Stock/ • Deduction of guarantee
Loan fees.
• Elimination or minimization
of U.S. withholding tax
 Treaties may provide lower
U.S.1 or 0% withholding rates on
Interest deduction interest.

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 Hybrid Mismatches – In General

 Generally, a country’s international tax rules only take into

account the application of that country’s rules to a cross-
border transaction, without regard to how the transaction is
treated under another country’s tax laws (or the combined
treatment of the transaction under both countries’ tax
laws).
• Often gave rise to “stateless income.”

 Globally, foreign countries were concerned with the

stateless income result. The Organization for Economic
Cooperation and Development (OECD), an
intergovernmental organization published a report intended
to neutralize hybrid mismatches and, as a result, prevent
stateless income arising from hybridity.
• Represented a major shift in how hybridity was viewed globally.
47
 Hybrid Mismatch Policies

Deduction/No Inclusion (“D/NI”) Double Deduction (“DD”)

Foreign U.S. Co
+ $100
Co

Hybrid U.S.: Interest

Instrument Expense Interest
Country A: ($100) DE
Exempt Dividend Bank
_
U.S. Co

$100 Operating
Foreign
$100
Income Sub

Group Economic Income: $100 Group Economic Income: $100

Group Taxable Income: $0 Group Taxable Income: $0

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Inbound - Repatriation/Withholding
 Once profits are earned in an FCC, the foreign MNE
will strategically plan to bring the money “home” (out
of the U.S.)

 To prevent income earned in the U.S. permanently

escaping U.S. taxation:
• Payments of U.S.-source FDAP income including dividends
by FCC to foreign person may be subject to withholding tax
(as may be modified by treaty).
• U.S. branch E&P shifted out of, or amounts of interest
deducted by, U.S. branch of foreign corporation may be
subject to branch profits tax or branch level interest tax.

49
B-3. Individual Outbound Taxation
 Individual Outbound

 Individual Outbound focuses on U.S. citizens or

resident aliens with foreign activities or foreign
investments.
U.S.

Foreign Foreign Bank

Foreign Account
Sub Foreign U.S. Sub
BR
Pass-thru

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 Individual – Jurisdiction to Tax
 Residency status is key to whether U.S. has
jurisdiction to tax an individual

 To determine whether the U.S. has jurisdiction to

tax the person in question, consider the following
issues:
• Determine whether the individual is a U.S. citizen,
resident alien, NRA or whether the individual is a bona
fide resident of a U.S. possession
− Resident Alien: lawful permanent U.S. resident (“green
card” holder); satisfies substantial presence test; or elects,
under certain limited circumstances, to be treated as a
resident alien.

52
U.S. Residency Status (pre-TCJA)

 U.S. citizens and resident aliens, whether residing

abroad or in the U.S., must file a U.S. federal
income tax return reporting their WW income from
both U.S. and foreign sources.

 Residents of a U.S. possession generally file a

single tax return with the territory of which the
individual is a resident and not with the U.S. Facts
and circumstances of each case are important to
determine whether individual is considered a bona
fide resident of a territory.

53
 Special Rules in Taxation
of U.S. Residents
 An individual may consider special applicable
rules in the cross-border context:
• Treatment of social security and self-employment taxes
for U.S. individuals working abroad;
• Treatment of cross-border pension plans;
• Compliance with expatriation tax rules; and
• Eligibility for any claimed credits, exclusions or special
treatment.

54
 U.S. Social Security and
Self-Employment Taxes
 When are taxpayers working abroad subject to
employment taxes?
• Answer: Look to status of employer (U.S., foreign, or
foreign affiliate of a U.S. MNE)

 When are taxpayers subject to self-employment

taxes?
• All U.S. citizens and resident aliens regardless of where
they live or work

55
 Cross-Border Pension Plans

 Participants in qualified domestic plans benefit from

favorable tax treatment. In general:
• Contributions to a domestic qualified plan by the taxpayer
or employer are not includible in taxpayer’s current
income.
• Earnings of a domestic qualified plan are tax-deferred.
• Distributions from domestic qualified plan are taxed when
received.

 Certain income tax treaties address the tax

treatment of contributions to a foreign plan, plan
earnings, and plan distributions.

56
Cross-Border Pension Plans (Cont’d)

 In the absence of an applicable treaty provision,

contributions and earnings of a foreign pension plan
for the benefit of a U.S. citizen or resident employee
are generally taxed much like the contributions and
earnings of a domestic non-qualified plan.
• Employee plan contributions are non-deductible for U.S.
income tax purposes;
• The employee may be taxed currently on employer plan
contributions; and
• Plan participants are taxable currently on plan earnings.

57
 Expatriation
 An “expatriation tax” is imposed on certain individuals
who relinquish their U.S. citizenship or end their U.S.
lawful long-term permanent resident (green card
holder) status:
• Generally applies only to certain high-income or high-net
worth individuals, but can apply to anyone who fails to
properly certify under penalties of perjury U.S. federal tax
compliance for preceding 5 years.
• Exceptions for certain dual citizens, but must still certify
compliance.
• Is a one-time tax on the unrealized gain of all property of the
expatriate (regardless of location), calculated as if the
property had been sold at its FMV on the day before the
expatriation date.
58
Individual Credits/Exclusions/Special
Treatments
 Eligibility for various credits, exclusions and special
treatment depend on satisfying various requirements to
claim these items.
• Credits
− Credits include the child tax credit/additional child tax credit,
recovery rebate credit, premium tax credit, making work pay
credit and earned income credit.
• Exclusions
− Certain qualified individuals may elect to exclude “foreign earned
income” and foreign housing costs from gross income, subject to
certain limitations.
− Foreign earned income is limited to a base exclusion amount that
is indexed for inflation.
• Special Treatment
− A U.S. citizen or resident alien employed by foreign government,
or living and working in a designated combat zone, may be
entitled to special treatment.
59
 Individual Foreign Tax Credit

 A U.S. individual earning income from outside the

U.S. may pay tax on that income to a foreign country.
Double taxation often results because the same
income is also taxable by the U.S.

 To mitigate this double taxation, a FTC is generally

allowed against the U.S. income tax liability for
foreign income taxes paid or accrued. This is the
same FTC we discussed earlier.

 The calculation of the FTC involves complex rules,

limitations and documentation requirements.

60
 Individual Creditability of FTC

 Foreign Tax Creditability Requirements

1. Taxpayer must have paid or accrued the tax
2. The tax must be imposed on the taxpayer by a foreign
country or possession of the U.S.
3. The tax must be the legal and actual foreign tax liability
4. The tax must be an income tax or a tax imposed in lieu of
an income tax

61
 Individual Calculation of FTC
 FTC General Limitation
• The FTC is generally limited to the amount of tax the
U.S. would have imposed on the taxpayer’s foreign
source income
• This is illustrated by the following formula:

FTC Limitation = Foreign Source Income x Total U.S. Tax

Worldwide Income

62
Individuals Investing in Foreign Entities

 A U.S. individual may invest or conduct foreign

activities through a foreign corporation or a foreign
pass-through entity.

 The individual may seek to minimize U.S. tax by

choosing a particular investment vehicle for his/her
foreign activities.

 Therefore, it is important to understand the differing

tax results of each entity type.

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 Individual Foreign Corporation
 Income earned by a U.S. individual investing through a
foreign corporation is not subject to U.S. tax until
distributed, unless it triggers one of the anti-deferral rules
listed below:
• Controlled Foreign Corporation – Similar to a domestic
corporation, a U.S. individual that is a U.S. shareholder in
a CFC will be subject to current U.S. taxation on the pro
rata share of a CFC’s subpart F income.
− However, the subpart F income is taxed at the individual rate (not
the corporate rate) AND an individual is not entitled to foreign tax
credits on any foreign taxes paid or accrued by the CFC.
− An individual MAY make a section 962 election to be subject to
tax on its subpart F income as if it were a domestic corporation
(but must still pay shareholder-level tax).
• Passive Foreign Investment Corporation – A U.S.
individual’s investment in a PFIC may also be subject to
current U.S. tax.
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Individual Foreign Pass-Through Entities

 A U.S. individual who conducts activities or

investments through a foreign pass-through entity will
be generally subject to U.S. tax on all income earned
through the entity on a current basis.

 An individual may make that investment through a

foreign pass-through entity such as:
• A foreign partnership
• A foreign disregarded entity or foreign branch
• A foreign trust

 Each pass-through entity will differ in how U.S. tax is

imposed.

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B-4. Individual Inbound Taxation
 U.S. Business Activities

 Nonresident aliens (NRAs) who engage in business

activities that create a U.S. trade or business or
permanent establishment (PE) may be subject to U.S.
tax.

 This is dependent on if an NRA has certain types of

income, including income effectively connected with a
U.S trade or business or profits attributable to a PE.
Special filing requirements and failure to file penalties
apply to NRAs.

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 U.S. Business Activities (Cont’d)
Example:
 During the tax year, an NRA F-1 student from China received
$10,000 in scholarship grants, $15,000 for working as a teaching
assistant and $8,000 for a summer job.


 The taxability of these amounts will depend on the type of income

and whether he is eligible for treaty benefits:
• The scholarship grant of $10,000 is exempt from U.S. tax under
Article 20(b) of the U.S.-China income tax treaty.
• The $15,000 from teaching and $8,000 from the summer job are
income from personal services, of which $5,000 is exempt from
U.S. tax under Article 20(c) of the treaty.

 All the taxable amounts are considered ECI and the taxpayer
should file Form 1040NR to report all the income and claim tax
benefits.
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 Withholding
 A nonresident alien (NRA) may engage in U.S.
investment activities and U.S. withholding taxes may
be imposed on income from those investments.
 U.S. withholding tax rules apply to payments of U.S.
source income to NRAs with respect to various types
of portfolio investments such as “FDAP” and “FIRPTA”
income.
 NRA is taxed on a sale of U.S. real property, and in
certain situations the sale of shares of domestic
corporations the business assets of which consist
mostly of U.S. real property.

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FDAP Withholding at Source

70
 Chapter 3 Requirements
 The WA must determine the correct amount of
withholding based on:
• Income type (e.g., interest, dividend)
• Source of income (U.S. vs. foreign)
• Payee status (U.S. vs non-U.S.; beneficial owner vs
intermediary or flow-through)
• Payee type (e.g., corporation vs. individual)
• Availability of treaty benefits or statutory exemptions

 Documentation is key.
 Presumption rules apply in the absence of
documentation.

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 Reporting Requirements
 Form 1042 must be filed by any withholding agent or
intermediary who receives, controls, has custody of,
disposes of, or pays a withholdable payment (including U.S.
source FDAP income).

 Generally, a single Form 1042 is filed consolidating the

information from all of the Forms 1042-S filed by the
withholding agent (whether the Form 1042-S reports an
amount with respect to Chapter 3 or Chapter 4).

 Form 1042 is an annual return filed with respect to the

previous calendar year.

 Form is required to be filed by March 15 (excluding

extensions).
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 Reporting Requirements (Cont’d)
 In addition to a set of Forms 1042-S filed with the IRS
copies of Forms 1042-S are sent to the to each
beneficial owner.

 Documentation must be provided to the withholding agent

before a payment is made. (W-8BEN,W-8BEN-E, etc.)

 In the absence of valid documentation (withholding

certificate or documentary evidence, if permitted), or if
the WA knows or have reason to know that the
documentation is unreliable or incorrect, WAs must
apply the presumption rules. Presumptions generally
result in 30% withholding tax.

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C. International Matrix (Pre- TCJA)
Introduction: LB&I International Program

 In 2010, LB&I implemented a new framework for

approaching the international tax area which has been
referred to as the International Matrix (but in the future
may be known as the International Knowledge Base)

 The goals were to:

• teach technical rules
• focus on key strategic priorities
• share knowledge through practice networks and a virtual
library of practice units

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The International Matrix

76
 The International Matrix (Cont’d)

 The International Matrix consists of five faces—Business

Outbound, Business Inbound, Individual Outbound,
Individual Inbound and Crossovers.
• It presents all areas (applicable to both businesses and individual
taxpayers) of international tax in a relatively simple framework.

 The International Matrix organizes international tax based

on the tax planning concepts from the Taxpayer’s
perspective, focusing on the most advantageous areas.
 The International Matrix is not tethered to the structure of
the Internal Revenue Code (IRC) or Income Tax
Regulations, but rather it presents a roadmap to allow an
examiner to quickly identify areas where audit time is most
warranted.
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 Internal Resources

The International Knowledge Management

Base
 Tax resources to aid in the examination of
Inbound and Outbound International issues
involving Businesses and Individuals.

 https://portal.ds.irsnet.gov/sites/VL008/Pages/def
ault.aspx

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 What Did We Learn?

You should now be able to:

A. Describe the basics of U.S international tax
(pre-TCJA)

B. Describe the differences between inbound and

outbound transactions

C. Explain the organization and content of the

International Matrix (pre-TCJA)

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Appendix
 Glossary of Terms

Acronym/Terms Definition
BR Branch
CFC Controlled Foreign Corporation
DD Double Deduction
DE Disregarded Entity
D/NI Deduction/No Inclusion
DRD Dividends Received Deduction
E&P Earnings and Profits
ECI Effectively Connected Income
ETR Effective Tax Rate
FC Foreign Corporation
FCC Foreign Controlled Corporation
FDAP Fixed, Determinable, Annual, or Periodic Income

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 Glossary of Terms

Acronym/Terms Definition
FIRPTA Foreign Investment Real Property Tax Act
FP Foreign Parent
FSTI Foreign-Source Taxable Income
FTC Foreign Tax Credit
GTOC Global Tax Organizational Chart
IP Intellectual Property
IRC Internal Revenue Code
MNE Multinational Enterprise
NECI Non-Effectively Connected Income
NRA Nonresident Alien
Organisation for Economic Co-operation and
OECD
Development

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 Glossary of Terms

Acronym/Terms Definition
PE Permanent Establishment
PFIC Passive Foreign Investment Company
TCJA Tax Cuts and Jobs Act
USTB U.S. Trade or Business
WA Withholding Agent

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