Fuad S. Saba
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Have you ever wondered what the professionals in your company’s tax department do? How are your company’s taxes computed and how do they affect your bottom-line Earnings per Share numbers? In this newsletter, we’ll provide information that will be useful for you to know, as a mobility professional, about corporate income taxation.
The 30,000 Foot Perspective
From a “macro” point of view, corporate income tax systems come in two basic forms: worldwide taxation and territorial taxation. You may have heard about deliberations and proposals in Congress regarding the feasibility of moving to a territorial system in the US. This is because the US federal corporate tax system is currently a worldwide system. What are the differences?
In a worldwide system, ALL of the income of a legal entity and its consolidated subsidiaries, as well as its foreign branches and subsidiaries, is, in principle, subject to income tax in the country where the “parent company” resides or is incorporated. This is how the US system works.
For US Generally Accepted Accounting Principles (GAAP) financial statement purposes, all of the operating results of the parent company, and its US and foreign subsidiaries and foreign branches, are consolidated as though they were one single business entity (there are exceptions for entities with minority ownership, certain joint ventures etc.). However, for US federal income tax purposes, unless special “anti-deferral” measures apply, the consolidated income tax group includes the operating results of the US parent company, its US subsidiaries, and any foreign branches of one of the US companies in the group, but not the results of foreign operating subsidiaries. This usually results in US consolidated taxable income being different from US GAAP consolidated income.
For example, ABC Company makes widgets in the US, and has wholly-owned sales subsidiaries in Germany and Hong Kong and a branch in the UK. Under US GAAP, all of the results of the US parent, its UK branch and the foreign subsidiaries are consolidated into one financial statement. Under the US tax system of worldwide taxation, the US results of ABC Company and the UK branch are reflected on the ABC US tax return, but, unless anti-deferral measures apply, the results of the foreign subsidiaries are not currently in US taxable income.
Paying the (Worldwide) Piper
Does this mean that the income earned by the foreign subsidiaries of a US group is never subject to US corporate income tax? Unfortunately not! There are four principal ways in which that income is ultimately taxed in the US.
- Foreign subsidiary earnings repatriated to the US as dividends. These dividends are taxable in the US (under current federal tax law, at a maximum federal rate of 35 percent.) If the earnings were taxed outside the US in the countries where they were earned, the US provides a “credit” that, in principle, prevents double taxation of the repatriated earnings. The foreign tax credit limitation computation is highly complex and can be influenced by many factors, both foreign and domestic. As a result, the credit system sometimes doesn't eliminate double taxation.
- Foreign subsidiary income subject to US “anti-deferral provisions”. Under these provisions, certain types of income in the hands of a “controlled foreign corporation” (CFC) of a US shareholder are not eligible for deferral from US taxation. Thus the income is taxed on a current basis to the US shareholder, even if no cash is repatriated from the subsidiary to the US parent. This is sometimes called a “deemed dividend distribution”. The anti-deferral rules are intended to prevent US shareholders from earning certain types of income in a CFC and delaying the impact of US taxation on that income. There are many anti-deferral mechanisms which will be described in a future newsletter. However, as in the case of foreign dividends, a foreign tax credit mechanism does exist to help eliminate double taxation of deemed dividend distributions.
- Gain on the sale or disposition of a foreign subsidiary in a taxable transaction. If a US shareholder disposes of the shares of a CFC at a gain, some of that gain, to the extent of the undistributed earnings in the CFC, is re-characterized as dividend income, and brings with it the foreign taxes on the undistributed earnings that can be claimed as a foreign tax credit. Any gain in excess of the undistributed earnings is taxed as capital gain.
- Liquidation of a foreign subsidiary into the US parent. This liquidation ends the deferral and triggers an income inclusion equal to the undistributed earnings in the subsidiary. This is taxed as a dividend in the hands of the US shareholder and brings with it the foreign taxes on the undistributed earnings, which may be claimed as a foreign tax credit. (This income inclusion applies in lieu of recognition of gain on the liquidation of the foreign subsidiary.)
Now you know the basics of a worldwide taxation system. In contrast, a territorial taxation system generally taxes only the income earned inside the limited "territory" of that taxing jurisdiction, but not income earned outside the territory. The following income earned outside that territory would not be taxable if received by a taxpayer subject to a territorial system:
- Dividends from active foreign subsidiaries.
- Remittances from active foreign branches.
- Gains on sales of active foreign subsidiary shares.
While certain anti-deferral measures exist to capture “passive” offshore income, they are much narrower than the range of anti-deferral measures under the US worldwide taxation system.
Most of the US trading partners that make up the 34 countries in the OECD (including the UK, Netherlands and Germany) are on some form of a territorial system. Under equivalent economic circumstances, a territorial system might generate less income tax revenue than a worldwide system. However, most of the countries that have adopted territorial taxation also have some sort of national consumption tax, such as a Value Added Tax (VAT), to generate substantial tax revenue. It will be fairly controversial to consider moving the US from the worldwide system to the territorial system, since the US presently does not have a national (federal) consumption tax in place.
With the above information in mind, and as you consider the potential corporate income tax impact of your mobile employees, you will want to know if the host jurisdiction taxes corporate income on a worldwide or territorial basis. As we will see in an example in a future newsletter, the difference can be significant.
The information provided is for general guidance only, and should not be utilized in lieu of obtaining professional advice.