International Taxation (Sanchirico)

Introduction
 2 Key Dimensions of International Tax
 Residence (US or Foreign Person)- Situs (location) of Income Earner
 Person
 Source (US or Foreign)- Situs of Income Itself- Situs of Economic Activity
Source
US Source Foreign Source
Residence US Person Box 1 Outbound
Income (Box 2)
Foreign Person Inbound Box 4
Income (Box 3)
 Basic Rules For Each Box

 Box 1 (U.S. Person/ U.S. Sourced Income)

 U.S. Taxes this income- these are the regular federal income tax rules

 Box 2 (U.S. Person/ Foreign Sourced Income)

 OUTBOUND INCOME
 (1) General Rule- WORLDWIDE TAXATION on U.S. Persons
 §61- “from whatever source [U.S. or foreign] derived”
 Contrast with Territorial Tax System- do not tax outbound income
 (2) Foreign Tax Credit
 Makes U.S. International tax regime more similar to territorial regime
 Steps
 (1) Calculate U.S. Tax Liability
 (2) Calculate Foreign Tax Liability
 (3) Give Credit for Foreign Taxes Paid Up to and not beyond your U.S. tax
liability
 If U.S. Tax < Foreign Tax- Pay all of Foreign Tax, and Pay $0 U.S. Tax
 If U.S. Tax > Foreign Tax- Pay all of Foreign Tax, and Pay Residual U.S.
Tax [Bite of Worldwide Tax System]
 U.S. Citizen pay maximum of two tax rates

 Box 3 (Foreign Person/ U.S. Sourced Income)

 INBOUND INCOME
 2 Main Regimes
 (1) “Active” Business Income- ECI & Permanent Establishment Tests
 Code: Effectively Connected Income- U.S. Taxed
 3 Main Components:
 Trade or Business- Entity Conducted with:

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  i) Profit Motive
 ii) Regular Basis
 Investment- Not Trade or Business
 Within United States- Facts and Circumstances Test- Case Law based
on Nexus with the U.S.
 Effectively Connected- All “Active” Income and “Passive” Income
that has Sufficient Factual Connection with the U.S.
 OLD RULE- “Force of Attraction” Rule- All U.S. Sourced Income
was taxed
 Treaty Overlay [Relief for Foreign Persons]: [Relief for Foreign Persons]
 In order for foreign citizen to be taxed
 A) Need Permanent Establishment in the United States AND
 B) Only the income attributable to that Permanent Establishment is
taxed
 (2) “Passive” Income- Withholding Regime-
 AUTOMATIC 30% Tax
 NO DEDUCTIONS
 Types of Income Subject to Withholding Regime
 (1) Dividends
 (2) Royalties
 (3) Gains from sale of real property
 Interest and Gains from sale of personal property are not subject to
withholding regime
 Treaty Overlay
 (1) Take Dividend Rate down to 15%
 (2) Royalties are Not Subject to Withholding Regime
 Ensures that Interest still not subject to withholding Tax
 Gains from sales of real property still subject to withholding tax

 Box 4 (Foreign Person/ Foreign Sourced Income)

 Generally- Not Taxed by United States
 Few Exceptions
 Withholding Regime
 ECI 3 Exceptions [§864c4]- Very narrow
 Abuse- U.S. Corporation doing business abroad creates a Foreign Subsidiary
 The foreign subsidiary becomes foreign person. Foreign Person/ Foreign Sourced
Income is not tax until bring income back to Parent Company
 Repatriation- Tax on bringing money back from Foreign Subsidiary to U.S.
Parent
 If Foreign Subsidiary is Irish Corp (12.5%), it is possible to transfer money to
Caribbean and pay 0% tax rate
 Deferred Tax System- In reality, becomes deferred income until money is
brought back to U.S. Parent becomes UNLIMITED IRA
 Source of Laws

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  Statute (Title 26 U.S. Code, Subchapter N §§860-999)
 Regulations- very useful, lots of examples
 Tax Treaties- Bilateral Instruments between U.S. and Another Nation
 Usually modifies Inbound Income taxes downwards
 Over 60 Different Treaties- Very Similar- Based on U.S. Model Treaty/ OECD
Models
 Notable Treaties- Ireland, Netherlands
 Legal Status- Art. 6- same level as statute- Follow Later In Time Rule
 Treaties Can be Overridden by Congress
 Note- No Treaties exist with Cayman Islands or Bermuda
 Treaty Approval Process- Signed by President, 2/3 Senate, No House
 Other- Constitution (Art. 3 & Am. 16), Rev Ruling/Admin Pronouncements, Cases

Source Rules (US v. Foreign Source)

 Importance
 If TP is Foreign Persons, source determines if taxed at All
 IF TP is U.S. Person- source determines potential of getting tax credit
 Source of Source Rules (§§861-65)
 §861- U.S. Source Rules
 §862- Foreign Source Rules
 §863- Mixed Sourced Rules
 §865- Rules for Sales of Personal Property
 Source Rules are based on kinds of income
 Interests
 Dividends
 Royalties & Rents
 Services/ Compensations
 Gain from Sale or Disposition or Property
 Real Property
 Personal Property
 Inventory
 Non-Inventory
 Interest Source Rules
 General Rule- Source=Situs of Payor (person paying the interest) §861(a)(1)
 Rule covers interest from govt bonds, corporate bonds (“bonds, notes or other
interest-bearing obligations”)
 Individual Rule (“noncorporate residence”) Source= Residence of Individual
 Corporation Rule (“domestic corporations”) Source= Situs of Incorporation
 Exceptions (3)
 That Harms TP [Make Foreign into US]
 (1) U.S. Branch- §861(f) [cross-reference to §884(f)]- Foreign Sourced Interest will
be treated as U.S. Sourced
 Branch- Foreign Business Operating Trade or Business in US that is not a
Separate Legal Entity (Not a Subsidiary)

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  That Benefits TP [Make US into Foreign]
 (2) Foreign Partnership- §861(a)(1)(C)- Predominantly engaged in business outside
US treat interest as foreign sourced if (i) not allocable to ECI or (ii) not paid by a
trade/ business engaged in by Pship in US
 in the case of a foreign partnership, which is predominantly engaged in the active conduct of a
trade or business outside the United States, any interest not paid by a trade or business engaged in
by the partnership in the United States and not allocable to income which is effectively connected
(or treated as effectively connected) with the conduct of a trade or business in the United States .
 §1.861(a)(2)(iv)- Interest paid by foreign partnership on trade/business in US is
US Sourced
 (3) Foreign Branch of Bank- §861(a)(1)(B)- Interest paid by a foreign branch of a
domestic corporation or partnership that is engaged in the commercial banking
business is foreign sourced.
 Dividend Source Rules
 General Rule- Sourced=Situs of Payor (Place of Incorporation for corporation paying
the dividend)- §861(a)(2)(A)
 Dividend- distributions of cash (or something else) to SH that is attributable to past or
current earnings or profits of corporation. Must be paid on a per share basis
 US Tax Law/Rates
 Dividend Rate for US Resident on US Corporation is 20%.
 Dividend for Foreign Person on US Corporation is 30% [Withholding Tax]
 Exception- 25% Rule- §861(2)(B)
 If >25% of foreign corporations gross income is “effectively connected” with U.S.
Trade or Business
 Then the proportion of the foreign corp’s income that is effectively connected
with US Trade or Business is U.S. Sourced. Rest of Dividend is foreign sourced
 If <25%- All of foreign corporations income is foreign sourced
 Services
 General Rule- Sourced where Service is Performed (Physical Location) §861(a)(3)
 90 Day Exception (aka Commercial Travelers Exception)- Not US Sourced IF
 (a) Foreign person in US <=90 Days
 (b) Compensation< $3,000 [this renders this exception essentially meaningless]
 AND (c) Services Performed for Another Foreign Persons
 Rents & Royalties
 Rule- Source= Place of Use (where property is Used)- §862(a)(4)
 Rents- payment for use of tangible property
 Royalties- payment for use of intangible property (where have privilege of using)
 Income for Sale or Disposition of Property

 U.S. Real Property

 Rule- §865(a)(5)- US Sourced if Real Property in US-

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  Applies if property directly owned
 If investment company own multiple pieces of real estate- proportion of US real
estate in company is US Source of share of investment company

 Personal Property

 Inventory
 Inventory- §1221(a)(1)- Property held by TP for sale to customers in ordinary
course of his trade or business (Price charged- COGS)- Huge chunk of income
 Not a capital asset
 General Rule- §1.861-7(c)- Two types of Inventory TP
 (1) Reseller- Source= Location where rights, titles and interest of the seller in
the property are transferred to the buyer. §1.861-7(c)
 TP has a lot of control over location of transfer
 US Sourced if Bought in US and Sold in US.
 US Sourced if bought in foreign country and sold in US
 Foreign sourced if bought in US and sold in foreign country
 (2) Producer and Seller- §1.861-7(d) [cross-reference to §1.863-3]- Divide
sourcing between production and selling
 50/50 Method- §1.863-3(b)(1)- Allot half of the income from sale, half of
the income from production. If do not like 50/50 Method, can elect for
another method [2 other methods are IFP and books and records’
 Selling Component- Source= Location where rights, titles and interest
of the seller in the property are transferred to the buyer. §1.861-7(c)
 Production Component- Source= Location of Production Assets
 §1.863-3(c)(1)(i)(C)- “a tangible production asset will be considered
located where the asset is physically located.” [Location of Plant &
Equipment]
 “An intangible production asset will be considered located where the
tangible production assets owned by the TP to which it relates are
located.” [Look at physical asset associated with intangible asset]
 §1.863-3(c)(1)(ii)(A)- If multiple plants in different country, U.S.
Source is proportion of plants in the U.S. based on their adjusted basis
 §1.863-3(c)(1)(ii)(B)- If a plant is used for multiple product,
proportion the asset based on how much of the plant is used for the
particular product
 Can use any method that reasonably reflect the proportion of
assets- One method that can use is proportion of gross receipts

 Example[§1.863(c)(1)(iv)(Example 1)- (i) A [U.S. corp] produces widgets

that are sold in US and abroad. The initial manufacture stage in US. The
second stage of production of widgets that are sold within a foreign
country is completed within the country of sale. A's U.S. plant and
machinery basis= $200. A foreign equipment basis= $25. A's gross
receipts from all sales of widgets is $100, and its gross receipts from
export sales of widgets is $25. Assume that apportioning average adjusted

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 basis using gross receipts is reasonable. Assume A's cost of goods sold
from the sale of widgets abroad is $13 and thus, its gross income from
widgets sold in foreign countries is $12. A uses the 50/50 method to divide
its gross income between production activity and sales activity.
 Step 1- Allocate $12 Gross income Between Manufacturing and
Selling
 Under 50/50 Method- $6 Allocated to Manufacturing, $6 to sale
 All of $6 for sale is U.S. Sourced
 Step 2- Calculate Percentage of Foreign Plant attribute to this widget
 Under Gross Receipts- $25 used for widget/ $100 used for all
assets.
 (25/100)*200 [Basis of Foreign Plant]= $50= Basis of Foreign
Plant attributable to widget
 Step 3- Calculate % production attributable to US.
 Basis Foreign= $50, Basis US= $25. Proportion US=1/4
 (25/(25+50)* $6=$2
 Step 4- Add Sale and Production= $8 (6+2) U.S. Sourced, $4 Foreign
Sourced

 Non-Inventory
 Rule- §865(a): Source= §865g Residence of Seller (not same as residence
elsewhere in code
 865g Residence
 Entity- Same rules as elsewhere in code. Corporation is U.S. 865g residence if
is a U.S. person. [U.S. Person for corporations are defined in §7701(a)(30)
 Individuals- §865g Resident= (A)(i)(I) U.S. Citizen or Resident Alien w/o
foreign tax home OR (II) Nonresident Alien w/ U.S. Tax Home
 Tax Home (defined in 911(d)- cross-referenced 162)- person’s regular
place of business or principal place of business
 If no regular or principal place of business, tax home= place of abode
with some exception
 If Nonresident alien does not have U.S. tax home Foreign 865g
resident
 Exception (for U.S. Citizens and Resident Aliens [entities and
individuals])- Will be a U.S. 865g resident (even with foreign tax home) if
foreign tax home will not tax you more than 10%: §865(g)(2)
 Ex 1- A=nonresident alien with no U.S. tax home. A= foreign 865g
resident. If A sells U.S. stocks in U.S.-->not U.S. Sourced. But if A gets
dividendsU.S. Sourced
 Ex 2- B=resident alien with foreign tax home. B= foreign 865g resident. If
B sells U.S. stocks in U.S.-->not U.S. Sourced (assuming foreign tax is at
least 10%). Note- capital gain rate in U.S. is 20%, non-capital gain 39.6%

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Residence Rules (US v. Foreign Persons)
 Importance- Reg. §1.1-1- U.S. will tax every citizen or residence on all income (whatever
source derived)
 4 Tests for Residence [for Individuals]
 (1) Lawful Permanent Residence or U.S. Citizen§7701(a)(30)(A)
 U.S. Citizen- born or naturalized in U.S.--> defined by immigration codes
 (2) Substantial Presence Test §7701(b)(3)
 (3) First Year Election §7701(b)(4)
 Substantial Presence Test: §7701(b)(3)
 Present >31 Days in U.S. this year AND
 In last 3 year  >184 weighted days present in the United States
 Weights Days= d1 + (1/3) d2 + (1/6) d3
 Day in current year (d1)=1x d1
 Day from Last Year (d2)=(1/3)x d2
 Day from Two Years Ago (d3)=(1/6)x d3
 Presence= Physically present for any part of the day- even a minute
 Exceptions
 Days that Don’t Count
 Day Sick and Can’t Leave- §7701(b)(3)(D)
 Days in US as diplomat, teacher, student or athlete §7701(b)(5)
 Closer Connection Exception §7701(b)(3)(B)
 (i) In U.S. < 183 physical days (pass substantial present test due to weighted days)
 (ii) Individual has foreign tax home & has closer connection to the foreign tax
home.
 Closer Connection- §301.7701(b)-2(d)- Facts and Circumstances Test based
on Significant Contacts that include the following factors
 (i) The location of the individual's permanent home; (ii) The location of the individual's
family; (iii) The location of personal belongings, such as automobiles, furniture, clothing
and jewelry owned by the individual and his or her family; (iv) The location of social,
political, cultural or religious organizations with which the individual has a current
relationship; (v) The location where the individual conducts his or her routine personal
banking activities; (vi) The location where the individual conducts business activities
(other than those that constitute the individual's tax home); (vii) The location of the
jurisdiction in which the individual holds a driver's license; (viii) The location of the
jurisdiction in which the individual votes; (ix) The country of residence designated by the
individual on forms and documents; and (x) The types of official forms and documents
filed by the individual, such as Form 1078 (Certificate of Alien Claiming Residence in
the United States), Form W-8 (Certificate of Foreign Status) or Form W-9 (Payer's
Request for TP identification Number).
 Ex1- Wolfang- unmarried German citizen work for German corporation. Year 1- 138
days in US, Year 20 150 days, year 3- 120 days in US. In US, owns house in Boston, car,
personal belongings, member of a club. Is he a US resident in year 3?
 Step 1-Substantial Present Test- He is in US for >31 days and his weighted days in
US is 120+1/3(150)+1/6(138)= 193>183

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  Step 2- Closer Connection Test- He is present for < 183 days, probably has a foreign
tax home (HQ in Germany- presumably principal place of work). Comes down to
whether he has closer connection with US or Germany- facts and circumstances test
 U.S. Entities
 Partnership, Corporation- §7701(a)(4)- The term “domestic” when applied to a
corporation or partnership means created or organized in the United States or under
the law of the United States or of any State unless, in the case of a partnership, the
Secretary provides otherwise by regulations. Residence= place of incorporation or
law under which partnership is organized under.
 Business Entity Def.- §301.7701-2(a)- entity not a trust. A business entity with 2+
people can either be corporation or partnership. Business entity with 1 individual
is either a corporation or a disregarded entity.
 Per se Corporation- Source is place where incorporated
 Eligible Corporation- can elect to be a corporation (any business entity)
 For U.S. Business Entity- Default is Partnership or Disregarded Entity
 For Foreign Business Entity- Default is Corporation
 Note- Publicly traded partnership is corporation

Inbound Income (Taxation of Foreign Person on U.S. Sourced

Income)
 Decision Tree
 Step 1- “Passive” or “Active”
 If Passive go To Withholding Regime
 If Active Go to Effectively Connected Test
ECI Regime
§871(b) Income connected with United States business—graduated rate of tax
(1) Imposition of tax
A nonresident alien individual engaged in trade or business within the United States during the
taxable year shall be taxable as provided in section 1 or 55 on his taxable income which is
effectively connected with the conduct of a trade or business within the United States.
(2) Determination of taxable income
In determining taxable income for purposes of paragraph (1), gross income includes only gross
income which is effectively connected with the conduct of a trade or business within the United
States.
Permanent Establishment
 Step 1- Treaty Overlay
 If Yes Not U.S. Tax

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  If No Go to Statute [Continue TO ECI test0
Effectively Connected Test
 Step 2- Is TP (i) “engaged” in U.S. (ii) “trade or business”?
 If not trade/businessnot ECI, no U.S. Tax
 If Trade/BusinessContinue
 Step 3- What is Source of Income?
 Foreign Source
 Step 4- Is there Fixed Place of Business?
 If noNot taxed if foreign sourced, if U.S. Sourcedcheck ECI
 If yes Step 5- is it ECI Type?
 If yes ECI
 If no Not taxed
 U.S. Source
 Step 4- Is activity on list of potentially accepted types of income (“periodic
income”)?
 If noOther Income= ECI
 If yes 2 test
 1) Asset Use Test
 2) Business Activity Test
 If pass either of these testECI
 If not not ECI

 OLD REGIME- Force of Attraction- all income from U.S. trade or business is taxed
Withholding Regime
§871(a) 30% Withholding Tax:
 Only to Extent Not ECI
 U.S. Sourced Income
 Foreign person
 FDAP (Basically Dividends & Royalties Remain)
 Interest that is not Portfolio Interest
 Dividends (with 25% Rule and 80-20 Exception)
 Gain from Sale Tangible/Intangible Property Excluded except those that are
contingent and U.S. Real Property Interest
 U.S. Real Property Interest is subject to ECI tax if property located in US
 Royalties are subject to Withholding
 Not Excluded in Treaty
 Art 11-Interest not Portfolio Interest Excluded by Treaty
 Art 10- Dividend Limited to 15%
 Art 12- Royalty Excluded (exceptions permanent establishment, related party
transactions)

 Trade or Business
 Mostly Defined by Case Law

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 Statutes- Only Marginally Helpful
 §864(b)- U.S. Trade or business includes performance of personal service but
does not include (i) performance of personal service for foreign employer and (ii)
trading in securities and commodities
 §875(1)- partner is engaged in trade or business if the partnership that the partner
is a member is engaged in a trade or business
 §875(2)- a trust beneficiary is engaged in trade/business if trust is
 Regulations- §1.864-2(e)- Whether trade/business is fact and circumstances tests
based off of case law.
 Case Law
 Entities- If SH of corporationnot engaged in trade or business but if partner in
partnershipengaged in trade or business
 Higgins
 F: Higgins devotes a lot of time managing his own investments (he hires
employee, has office, makes profits, and spends lots of time). He has 2 kinds
of investments (1) Bonds, Stocks (2) Real Estate.
 H1: Managing your own investmentsNot Trade or Business
 Investor (regardless of amount of time being spent)=simply SHNot
Trade or business. Trader/dealer (other people’s money) trade/business
 H2: Real estate management (requires actively management) = Trade/business
 Note- Overly simplistic holding- anybody involved in financial market is not
engaged in trade or business unless if broker/dealer
 Suncastle- Private equity investor is trade/business, regular investor is not
 b/c private equity investor actually gets involved in management of companies
 Continental Trading
 F: TP manages investment and runs small milk business (buy one car load
milk fat, some tin cans, and a little bit of equipment)
 H1: Reaffirms Higgins
 H2: Milk business was too sporadic. Not regularNot Trade or business
 Balanouski
 F: 80% P of Pship that buys equipment for Argentina govt. P in U.S. for 80
days. In 80 days very active (bargain prices, inspect equipment, warehouses,
develop new business)
 H: TP very active when in USdeeply engaged in trade or business
 Handfield
 F: Canadian make post cards, sell in US using distributor who is newsstands.
TP determines the price of the postcards and any postcards that the
newsstands don’t sell, TP will take back
 H: When someone acts as your agent, you become a trade/business
 Agent if principal retains control (determines price of postcards) and bears
all the risk (takes back the cards that are not sold
 Rev-Rul 70-424
 F: M- foreign corp, Q- Domestic corp. M approves contracts (retains control)
and is a guarantor (bears risk) but M agrees to share 1/2 the risk
 H: Q is M agent. Thus, M has U.S. trade or business

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 ECI (“Active Income”)

 Potential ECI List (Periodic Income)- §864c2

 On List- §871(a)(1)- FDAP, §871(h)- Portfolio Interest & gain/losses from capital
asset
 Includes Capital income, Dividends, Passive/Periodic Income such as Rents,
interests
 General Rule- If on Potential ECI list, become ECI if pass the (A) Asset Use Test OR
the (B) Activities Test

 (A) Asset Used Test-

 “the income, gain, or loss is derived from assets used in or held for use in the
conduct of such trade or business” §864c2(A)
 1.864-4(c)(ii)- 3 Types: (1) Principal purpose is present conduct (not future
investment) (2) account receivables (3) Direct relationship
 (a) “Held for the principal purpose of promoting the present conduct of the
trade or business in the United States [Example- Rent from a rental building];
or
 (b) Acquired and held in the ordinary course of the trade or business
conducted in the United States, as, for example, in the case of an account or
note receivable arising from that trade or business; or
 (c) Otherwise held in a direct relationship to the trade or business conducted
in the United States, as determined under paragraph (c)(2)(iv) of this section.”
 1.864-4(c)(iv)-Direct Relationship Test 2 Further Tests (a) Presently
Needed or (b) Presumption
 (a) Presently Needed- “only if the asset is held to meet the present
needs of that trade or business and not its anticipated future needs.”
 Example of Future Needs- “the asset is held for the purpose of
providing for (1) future diversification into a new trade or
business, (2) expansion of trade or business activities conducted
outside of the United States, (3) future plant replacement, or (4)
future business contingencies.”
 (b) Presumption- Presume a direct relationship “if (1) the asset was
acquired with funds generated by that trade or business, (2) the income
from the asset is retained or reinvested in that trade or business, AND (3)
personnel who are present in the United States and actively involved in the
conduct of that trade or business exercise significant management and
control over the investment of such asset.
 Presumption is rebutted if assets are used for future needs
 Example 1- [§1.864-4(c)(2)(v)]- M, a foreign corp engaged in
manufacturing in a foreign country. M maintains a U.S. branch which acts
as importer/distributor of the merchandise it manufactures abroad. The
branch is required to hold a large current cash balance for business
purposes, but the amount of the cash balance so required varies because of
the fluctuating seasonal nature of the branch's business. During 1968 at a

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 time when large cash balances are not required the branch invests the
surplus amount in U.S. Treasury bills.
 T bills interestpotential ECI List. T bills are held to meet the present
needs of the business  direct relationship pass asset used
testECItaxed
 Example 2- Foreign corporation M has U.S. branch office where it sells to
U.S. customers various products which M manufactured abroad. The U.S.
branch establishes in 1997 a fund to which are periodically credited
various amounts which are derived from the business carried on at such
branch. The amounts in this fund are invested in various securities issued
by domestic corporations by the managing officers of the U.S. branch,
who have the responsibility for maintaining proper investment
diversification and investment of the fund. During 1997, the branch office
derives from sources within the United States interest on these securities,
and gains and losses resulting from the sale or exchange of such securities.
 Securities Interestpotential ECI list. Presumption (1) Securities
bought from fund generated by trade/business √ (2) Assets retained by
trade/business √ (3) Personnel actively involved in T/B exercise
significant management over assets √ Presumption met. However,
M is able to rebut this presumption b/c fund used for future
expansion future needs rebuttal Not ECI.

 (B) Business Activities Test

 “the activities of such trade or business were a material factor in the realization of
the income, gain or loss” §864c2(B)
 “Arises directly from the active conduct of the TP” §1.864-4(c)(3)(i)
 Examples: §1.864-4(c)(3)(i)
 (a) Interest and Dividend Income for a Dealer in Stocks and Bonds
 (b) Gain/Losses from Investment Company
 (c) Royalties from Patent Licensing Company
 (d) Service Fee from a Servicing Business
 Example 2 §1.864-4(c)(3)(ii)- N, a foreign corporation has U.S branch in
which acts as an importer and distributor of merchandise. N also carries on a
business in which it licenses patents to unrelated persons in the US for use in
the US. The businesses of the licensees in which these patents are used have
no direct relationship to the business carried on in N's branch in the U.S.,
although the merchandise marketed by the branch is similar in type to that
manufactured under the patents. The negotiations and other activities leading
up to the consummation of these licenses are conducted by employees of N
who are not connected with the U.S. branch and the U.S. branch does not
otherwise participate in arranging for the licenses.
 Royalties from these licenses are not ECI b/c the activities of that business
are not a material factor in the realization of such income.

 “Other ECI”

12
  864(c)(3) All Income, Gain or Loss (other than those on the “potential ECI list”) in
the U.S. for foreign person engaged in trade/business with U.S. Sourced income will
be treated as ECI
 §1.864-4(b): This income, gain, or loss shall be treated as ECI with the conduct of
a trade or business in the United States, whether or not the income, gain, or
loss is derived from the trade or business being carried on in the United
States during the taxable year.
 Even if occasional sale from completely different business, will be ECI
 For this reasonshould create foreign subsidiary instead of branch office.
 Example 1- [§1.864-4(b)] M, Foreign Corporation engaged in manufacturing has
branch office in U.S. where it negotiate sales, solicits orders. [that income is treated
as ECI]. Occasionally, customers in U.S. write directly to the home office of M, and
the home office makes sales directly to such customers without routing the
transactions through its branch office
 Since M is engaged in U.S. trade or business with U.S. sourced income, all of its
income (not on the potential ECI lists) will be treated as ECI. Therefore, income
directly to home office is ECI (even though not derived from trade or business
being carried on in U.S.)
 Example 3- Foreign corporation S- purchasing/selling electronic equipment both in
home office and in U.S. branch office. The home office but not the branch also
engaged in the business of purchasing/selling vintage wines. As a result of
newspapers ads, U.S. customers frequently place orders for the purchase of wines
with the home office in the foreign country, and the home office makes sales of wine
directly to such customers without routing the transactions through its branch office
in the United States.
 S is engaged in trade/business with U.S. sourced income. Therefore all of its
income (not on the potential ECI list) in the U.S. even if not carried on by trade or
business in U.S. is ECI. That includes both the electronics and the wine sales.

 Foreign Sourced IncomeECI

 §864c4(A)- Generally, foreign sourced income not ECI.
 3 Exceptions §864c4(B)- Foreign source income of foreign person will be ECI if
 TP has fixed place of business in the U.S. AND either
 (i) Rents or royalties from intangible property [such as patents]
 (ii) Banking business’s dividends, interest OR
 (iii) Income from sale or exchange (outside U.S.) of Inventory Property except if
(a) the inventory property is sold for use, consumption or disposition outside the
U.S. AND (b) a foreign office participated materially in such sale
 §864c4(B)(iii) has very limited application due to §865(e)
 §854(e)(2)(A) Sale of 865g- nonresidents: “if [865g] nonresident maintains an
office or other fixed place of business in the U.S., income from any sale of
personal property (including inventory property) attributable to such office or
other fixed place of business shall be U.S. sourced
 In other words- 865e already makes this income U.S. sourced and thus
subject to the ECI regime.

13
  The only application of §864c4(B)(iii) is to a nonresident who is a 865g
U.S. resident [very narrow pool]
 Note- 865e2 has similar exception as 864c4Biii- “Subparagraph (A) shall
not apply to any sale of inventory property . . . if an office or other fixed
place of business of the TP in a foreign country materially participated in
the sale.”

 ECI Deductions and Credits

 §871(b) which imposes the ECI regime only imposes it on taxable income [not net
income], implying that TP must figure out deductions
 §873- DEDUCTIONS- (a) “In the case of a nonresident alien individual, the
deductions shall be allowed [only in the ECI regime and not withholding regime]
only if and to the extent that they are connected with [the ECI] income”
 Exceptions- 873(b)- Individuals can deduct losses for charitable contributions and
personal exceptions (only get one exemption with exceptions)
 Corporate Rules Mirror Except do not allow personal exemptions
 §882(c)- In the case of a foreign corporation, the deductions shall be allowed only
for [the ECI regime, not the withholding regime] only if and to the extent that
they are connected with [ECI] income”
 Exceptions- Charitable Contributions-allowed if not connected to ECI income
 Special Rules for Interest Deductions- Note- Money is very fungible making interest
very difficult to attribute [TP will try to maximize ECI interest deduction]
 Foreign Individuals
 §1.861-9T(d)(iv)(2)(i)- Interest is ECI deductible (i) if entered into books and
records of a U.S. trade or business OR (ii) interest secured the ECI assets
 80% Limitation- §1.861-9T(d)(iv)(2)(ii)- Gross liabilities cannot exceed
80% of the gross assets
 Interest-Stripping (aka Earning Stripping) Example
 EX1- Marcel is foreign individual. He has business opportunity in US that
if he contributes $1M, he will get $150K a year. Without income
stripping, Marcel will pay U.S. tax on $150K
 EX2- Marcel now creates a foreign corporation which he contributes
$800K. From the foreign corporation, Marcel borrows $800K with a 12%
interest rate. Marcel uses the money from the loan and $200K to
contribute the $1M to the business opportunity.
 Each year when he gets a $150K, he will get a $96K (12% interest)
interest deduction [here the interest secured the ECI asset]. Marcel will
only pay U.S. tax on $54K.
 Note- Could only borrow $800Kto abide by the 80% limitation.
 Note- This is allowed because foreign corporation is considered
separate person
 Note- Marcel will have to pay $96K to his foreign corporation and will
be taxed (presumably abroad) when he takes the money out of the
corporation (acts like an IRA in that it defers taxes)
 Note- Marcel could not take advantage of interest stripping if he was
an corporation due to formulaic apportionment

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  Foreign Corporation
 §1.882-5- Formulaic Apportionment to determine interest expense
attributable to U.S Trade and Business
 Compute Actual Ratio- Total worldwide Liabilities/Total worldwide
Assets
 Compute Liabilities in U.S. by multiplying the Actual Ratio by total U.S.
Assets
 Interest Rate is computed in two ways
 If Computed U.S. Liabilities> Actual U.S. Liabilities paid, then
interest rate is the average interest rate paid worldwide on U.S. Dollar
liabilities
 If Computed U.S. Liabilities< Actual U.S. Liabilities paid, then
interest rate is the actual interest rate paid in the United States.
 Ex- Actual Ratio=60%, U.S. Asset is $500, interest rate=10%.
 Computed U.S. liabilities is $300 [60%*$500]
 Computed Interest Expense is $30 [10%*$300]
 Permanent Establishment (Treaty)
 Trigger- Need Permanent Establishment, Net- only taxed on income attributable to
the Permanent Establishment
 Article 7(1) - The profits of an enterprise of a Foreign State shall be taxable only in
that State unless the enterprise carries on business in the U.S. through a permanent
establishment situated therein. If the enterprise carries on business as aforesaid, the
profits of the enterprise may be taxed in the U.S. but only so much of them as are
attributable to that permanent establishment
 Definition of a Permanent Establishment
 Art. 5 (1) “For the purposes of this Convention, the term “permanent establishment”
means a fixed place of business through which the business of an enterprise is wholly
or partly carried on.”

Examples of Permanent Establishments

 Art. 5 (2) “The term “permanent establishment” includes especially:
 a) a place of management; b) a branch; c) an office; d) a factory; e) a workshop;
and f) a mine, an oil or gas well, a quarry, or any other place of extraction of
natural resources.”

Examples Not Permanent Establishments

 Art. 5 (4) “Notwithstanding the preceding provisions of this Article, the term
"permanent establishment" shall be deemed not to include:”
 Warehouses for “storage, display or delivery of goods” or “purpose of processing
by another enterprise”; purchasing office or office that collect information;
 a fixed place of business solely for the purpose of carrying on, for the enterprise,
any other activity of a preparatory or auxiliary character;
 Note Defined- Probably includes advertisements

Agency
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  Art. 5 (5) “a person -- other than an agent of an independent status -- is acting on
behalf of an enterprise AND has and habitually exercises in a U.S. an authority to
conclude contracts that are binding on the enterprise, that enterprise shall be deemed
to have a permanent establishment”
 Art. 5 (6) “An enterprise shall not be deemed to have a permanent merely because it
carries on business in that State through a broker, general commission agent, or any
other agent of an independent status, provided that such persons are acting in the
ordinary course of their business as independent agents.”
 Hanfield is the foremost case on independent agentthe two important factors are
retained control & bearing risk

Parent & Subsidiaries [Respect Corporate Veil]

 Art. 5 (7) Parent with permanent establishment does not necessarily mean subsidiary
has permanent establishment (could get permanent establishment status via agency)
 Likewise, Subsidiary with permanent establishment does not necessarily mean parent
has permanent establishment (could get permanent establishment status via agency)

 Net- Attributable to Application

 Art. 7(2)- Where a foreign enterprise carries on business in the U.S. through a
permanent establishment situated therein, there shall in each Contracting State be
attributed to that permanent establishment the profits that it might be expected to
make if it were a distinct and independent enterprise engaged in the same or
similar activities under the same or similar conditions. For this purpose, the profits to
be attributed to the permanent establishment shall include only the profits derived
from the assets used, risks assumed and activities performed by the permanent
establishment.
 National Westminster- For a British banking company, a U.S. branch making
loans to U.S. person was getting money from U.K. headquarters. U.S. had to pay
interest back to U.K. headquarters. 2 approaches to determine what interest is
attributable to U.S. permanent establishment (here, no question that U.S. branch is
permanent establishment)
 1) Under 1.882-5- determine interest allocation based on formulaic
approach= (worldwide Liabilities/ worldwide Assets) * U.S. Assets
 2) Art. 7- distinct and independent enterprise standard
 Since treaty came later, it overrides if conflict
 Court rules conflict because 1.882-5 ignores intercompany loans and
attribute U.S. interest based on worldwide metrics.

 Difference between Treaty and Code

 For Wine and electronic example (sell electronic in branch and home office, sell wine
only in home office) wine will not be attributable to U.S. branch and thus while
would be taxed under code (see other ECI rules), would not be taxed with treaty
overlay
 Is treaty necessary? Foreign Corporation in non-treaty state can probably get
similar results via domestic law if it creates a foreign subsidiary that does all the

16
 U.S. sourced activity. So if U.S. branch would be a U.S. subsidiary, then parent
would not be U.S. sourced and thus the wine income will not be U.S. taxed
 Branch Profit Tax
 Ex- Foreign Corp has U.S. Brach. U.S. Branch makes $100,000. Foreign corp takes
$50,000 out of U.S. Branch (title has not changed). After 1986, $50,000 that moved out
of U.S. is taxed at 30% in addition to possible ECI taxes paid on the $100,000
 Rationale- equalize tax treatment of U.S. Subsidiary and U.S. branch that is not a
subsidiary
 Flaw- U.S. Corporations are generally taxed differently than non-corporation
throughout the tax code.
 Three Ways Foreign Corp can do business in U.S.
 1) U.S. Chartered subsidiary in U.S
 Layer 1- U.S. Corporate Income Tax
 Layer 2- Dividend back to foreign corporation
 §861(a)(2)- Source of Dividend- Situs of Payor (corporation paying
dividends)- here U.S.
 §871(a)- U.S. sourced dividend income on foreign person is subject to
30% withholding tax
 2) Foreign Charter subsidiary business in U.S.
 Layer 1- ECI Regime--§882(a) & Treaty Art. 5 (permanent establishment) -
foreign corp engaged in trade or business within U.S. has U.S. ECI
 Layer 2- Withholding tax on Dividends (see §861(a)(2)/ §871(a))
 3) U.S. Branch/ Division doing business in U.S.
 Layer 1- E.C.I.
 Layer 2- Branch Profit tax
 §884- Branch Profit Tax-
 (a) In addition to the tax imposed by §882 (corporate ECI) for any taxable year, there
is hereby imposed on any foreign corporation a tax equal to 30 percent of the
dividend equivalent amount for the taxable year.
 §316- dividends= (1) Distribution of property (money) from corporation to SH
and (2) money that come from earning & profits
 [not just a return on principal, which reduces basis]
 §312- Earnings & Profits= Net inflows to the corporation. Using reservoir
analogy, look at what flows into reservoir in a given year and what flows outs.
 Look at what in corporation this year and subtract earning/profits
distributed to owners and deductibles including taxes paid
 (b) “dividend equivalent amount” = foreign corporation’s ECI earnings and
profits for the taxable year adjusted by changes in U.S. net equity
 Look at inflow in U.S. branch (Earnings & Profits) and end of the year cash in
U.S. branch to determine amount that flowed to foreign corporation
 (1) Outflow to Foreign Corp= E&P – (increase in U.S. Branch net equity); OR
 Ex- $100 Flow in, Net Equity increase by $60, $40 must went to foreign
corporation ($12 branch profit tax)
 (2) Outflow to Foreign Corp= E&P – (decrease in U.S. Branch net equity)

17
  Ex- $100 Flow In, Net Equity decrease by $60, $160 went to foreign corp
($48 branch profit tax)
 Withholding Tax (“Passive Income”)
 Bottom-line- Dividend (15%) and Royalties (30%) only thing hit with withholding tax
 FDAP (“Fixed and Determinable Annual or Periodic Gain”) taxed at 30%- no
deductions
 §871(a)- tax of foreign individuals,
 §881- tax on foreign corporations
 §1441- tax withheld by individual payors
 §1442- tax withheld by corporate payors

 Statutory Framework
 §871(a)(1)- Income other than Capital gains-
 Except as provided in subsection (h) (“Portfolio Interest”), there is hereby
imposed for each taxable year a tax of 30 percent of the amount
 1- received from U.S. sourced income
 2- by a foreign person-
 §871(a)(1)-nonresident alien individual (§881- foreign corporation)
 3- on FDAP (“Fixed and Determinable Annual or Periodic Gain”)
 4- but only to the extent the amount so received is not ECI.

 FDAP
 On List- §871(a)(1)(A)-
 interest (other than original issue discount), dividends, rents, salaries, wages,
premiums, annuities, compensations, remunerations, emoluments, and other
fixed or determinable annual or periodical gains, profits, and income
 Royalties not on list but included in ECI
 §871(a)(1)(B)- Original Issue Discount
 Bond doesn’t pay bond interest until when principal is repaid- originally
created to convert interest income into capital gains- today taxed as imputed
interest income
 Ex- Zero Coupon Bond
 §871(a)(1)(C)- Sale/Exchange of IP (attempt to disguise royalty)
 Hard to distinguish between buying portion of property interest as opposed to
renting or royalty
 Ex- not renting property but selling right to use property for a month
 §871(a)(2) Capital Gain- Null Set
 30% Withholding tax if
 §865g foreign person
 >183 days in U.S. (Pass substantial presence test) U.S. Resident
 U.S. sourced capital gain ECI to T/B

 Interest

18
 Interest Source Rules- §861(a)(1) Source=Situs of Payor (person paying the interest)
with exception of foreign branch of U.S. Bank
 Withholding-Covered in §871(a)(1)(A) FDAP list BUT not withholding tax if:
 1) ECI-§871(a)(1)
 2) Portfolio Interest- §871(h)
 3) Interest on U.S. Bank Deposits- §871(i)
 Portfolio Interest- (Most of All Interest)
 §871(h)(1) no withholding tax on portfolio interest
 §871(h)(2) Portfolio Interest- Interest paid on obligation in registered form &
certified to foreign person.
 Certified by either self-certification or secretary says unnecessary to certify
 Major Exception-
 1) §871(h)(3)(B) 10% SH- If 10% SH, not portfolio Interest and pay withholding
tax
 “10-percent shareholder” means—
 (i) any person who owns 10 percent or more of the total combined voting
power of all classes of stock of a corporation entitled to vote, OR
 (ii) any person who owns 10 percent or more of the capital or profits
interest in such partnership.
 §871(h)(3)(C) Be aware of §318- Attribution rules- Includes rules about
related persons and other attribution rules
 Rationale- prevent disguised dividend
Ex- US T/B cost $1M, makes $150K per year
 Scenario 1- Marcel lends U.S. Corporation $800K and gives its $200K.
 U.S. Corporation deduct $96K interest expense, pays taxes on $54K
 Marcel pays withholding tax on $96K: U.S. Sourced (payor U.S. Corp),
paid to foreign person (Marcel), Not ECI. Would be withholding but for
10% SH exception.
 Scenario 2- Marcel lends $800K to U.S. branch of Foreign corporation and
gives $200K cash.
 Foreign Corporation pays taxes on $54K as ECI
 On 96K, Marcel subject to withholding tax- for purposes of income tax,
any interest paid by U.S. T/B shall be taxed as domestic corp
 Scenario 3- Marcel lends $800K to Foreign corporation, which in turns give to
U.S. Branch- still tax due to attribution rules
 Scenario 4- If Odette marries Marcel, Odette makes loan. §318- attributed to
Marcel making loan
 2) §881(c)(3) Paid by Foreign banking Corporation in U.S. T/B
 A) Not paid on U.S. Govt bond
 B) from bank extension of credit pursuant to loan agreement
 C) Pursuant to ordinary course of business
 Generally this is ECI but possible bank doesn’t have U.S. branch even if
engaged in U.S. trade or business
 3) §871(h)(4) Contingent Interest- disguised interest- any receipt, sale cash flow
to person who is debtor or related persons

19
  4) §871(i)(1) Interest Paid to Foreign Bank from U.S. Persons on Bank Deposit is
resourced as U.S. Sourced
 5) §871(i)(2) Old 80-20 Rule (repealed exception)- If U.S. corporation does 80%
of their business abroadconsider it foreign person (grandfather before 2010)


Grandfather
Interest on Bank WITHHOLDING
ECI Yes US Source Yes Porfolio NO No under 80-20 NO
Deposits TAX
Rule

Obligation is Paid to
Payee 10% Contigent PORTFOLIO
Registered YES NO Foriegn NO NO
SH Interest INTEREST
and Certified Banking Corp
 Treaty Overlay- Art. 11 Interests
 Art. 11(1) Interest arising in a U.S. beneficially owned by foreign person may
only be taxed by foreign state
 Art 11(2)- Exceptions- disguised dividends, portfolio interest, etc.

 Dividends
 Dividend Source Rules-General Rule- Place of Incorporation of Payor.
 Exception- 25% Rule- If foreign corp> 25% U.S. Business then % of U.S.
business is % that corp is U.S. sourced
 Repealed Exception- 80-20 Rule- If 80% of U.S. Corp business is foreign
sourced 100% foreign
 Dividend Withholding Rule- general rule- dividends are subject to withholding- on
FDAP list §871(a)(1)(A)
 Exceptions (1) Grandfather 80-20 Rule and (2) 25% Rule
 §871(i)(2)(B) Grandfather 80-20 Rule- If U.S. corp is doing 80% of business
abroad and was a grandfathered 80-20 company, no withholding tax
 §871(i)(2)(D)- If company becomes U.S. source due to 25% Rule [§861(a)(2)
(B)], then not subject to withholding tax
 Used to be 2nd tax on dividends (once through ECI and once through
withholding, no longer tax replaced by branch profit tax
 Treaty Overlay- Art. 10 Dividends
 Art 10(1)- Dividend paid by U.S. corporation to foreign resident may be taxed by
United States (and by foreign state).
 Art 10 (2)- However, for dividend that are beneficially owned by foreign person,
the U.S. tax cannot exceed
 a) 5% if the beneficial owner owns at least 10% of voting stock; OR
 b) 15% in all other situations (Down from 30%)
 Japan//Norway tax treaties eliminate dividend taxes altogether

 Intangible Property/Royalties

20
  Source Rules- Intangible Property Sale is sourced based on place of location of sale
and location of tangible property which intangible is based off of if it is inventory
property and source based on §865(g) residence of seller for noninventory
 Royalty/ Contingent Sale- sourced based on location of use
 Types of Intangible Property
 1) Periodic Royalty- subject to withholding even though not on FDAP list
 2) Gain from sale of intangible property- not contingent no withholding tax
§871(a)(1)(D)-
 3) Gain from sale of intangible property where payment is contingent- §871(a)(1)
(D)- subject to withholding tax to extent it is contingent
 Very Complicated to discern differences between a sale and a royalty
 Case Law- If capture exclusive right to use intangible property in a
territory (only person who can use peter pan in U.S.) or a field of use (only
person to use Peter Pan in movie form), then it is sale
 Wodehouse- Author gets paid lump sum for serial novel collection. The seller retains
lots of rights (the sale is not territory or field of use exclusive. Since the seller retains
many rights, this is a royalty and thus subject to withholding tax despite lump sum
payment.
 4) Capital Gains- §871(A)(2)- null set
 Treaty Overlay- Article 12- Royalty
 Art 12(1)- royalty arising in U.S. and beneficially owned by foreign resident may
only be taxed by foreign country.
 Art 12(3)-(4)- exception- permanent establishment, related party transactions

 Sale/Disposition of Tangible Property

 Source Rules- Tangible Property Sale is sourced based on place of location of sale
and location of tangible property which intangible is based off of if it is inventory
property and source based on §865(g) residence of seller for noninventory.
 Inventory often be ECInot subject to withholding (if inventory does not have
fixed place of business can be non-ECI but since not on FDAP lists, not subject to
withholding
 Gain from sale/disposition of tangible property is not subject to withholding tax
 Special Rule for Real Estate (see next section)
 §871(a)(1)(D)- not capital gains- not on FDAP list- only subject to withholding
tax if contingent
 §871(A)(2)- Capital gains- null set
 Foreign Investment Real Property Act
 Real Property is taxed stricter that ECI because do not allow certain deductions
 Source Rule- §861(a)(5)- U.S. Sourced if real estate is located in U.S (U.S. Real Property
Interest)
 §897(a)- disposition of real property interest by foreign persons is taxed as ECI but does
not allow certain deduction in AMT
 §897(a)(2)- Don’t get exemption amount for AMT from sale of U.S> real property
interest

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  Note- Passive Real Estate investment becomes ECI
 §897(c)- Real Property Interest- “United States real property interest” means—
 (1) an interest in real property (including an interest in a mine, well, or other natural
deposit) located in the United States, AND
 (6) “interest in real property” includes fee ownership and co-ownership of land,
leaseholds of land (right to lease land), options to acquire land, and options to
acquire leaseholds
 1.897-1(d)(1) interest of creditor is not U.S. real property interest
 (2) U.S. Real property holding corporation that FMV of U.S. real property interest >
50% of overall FMV of all real property (look through corporate veil in order to make
this calculation)
 Odd because this change each year. If at any time the ratio is met-taxed as ECI
 Exception-
 1) §897(c)(3) stock regularly traded on exchange and TP own more than 5% of such
class of stock
 2) §897(c)(1)(B)- If corporation sell or exchange real estate during 5 years and as a
result ratio met SH doesn’t worry about ECI
 §897(d)(1)- gain shall be recognized by a foreign corporation on the distribution of a
United States real property interest.
 Treaty Overlay- Art. 13- Gain derived by foreign resident attributable to U.S. real
property interest may be taxed in the United States.

Outbound Taxation (Taxation of U.S. Persons Outside U.S.)

 Tax Credit
 Purpose
 Prevents Double Taxation
 U.S. Person can be taxed for the same activity by the U.S. and by the foreign
government. Ex- U.S
 (also prevent NO Taxation)
 U.S. Solution to double taxation is Foreign Tax Credit (FTC)
 Credit is for the lessor of the foreign income tax paid for foreign sourced income and
what U.S. income would have paid for the foreign sourced income but for the credit
 Result- U.S. Citizen pays the higher of the U.S. and Foreign Tax
 U.S. taxes on residual, if any.
 If U.S Tax on FS Income> Foreign Tax on FS Income. Person pays all of Foreign
Taxes and pay a Residual Tax to the United States.
 The Residual Tax is what makes the United States a worldwide tax system,
rather than a territorial tax system.
 If U.S Tax on FS Income< or = Foreign Tax on FS Income. Person pays all of
Foreign Taxes and pay United States no tax on Foreign Sourced Income
 Tax Provisions
 U.S. gives deduction and credit but takes away Deduction and limits credit
 Deduction

22
  §164(a)- Except as otherwise provided in this section, the following taxes shall be
allowed as a deduction for the taxable year within which paid or accrued:
 (1) State and local, and foreign, real property taxes.
 §275(a)- No deduction shall be allowed for the following taxes:
 (4) Income, war profits, and excess profits taxes imposed by the authority of
any foreign country or possession of the US if the TP chooses to take to any
extent the benefits of § 901.
 Credit
 §27(a) Foreign tax credit- The amount of taxes imposed by foreign countries and
possessions of the United States shall be allowed as a credit against the tax
imposed by this chapter to the extent provided in section 901.
 §901- Taxes of foreign countries and of possessions of United States
 (a) Allowance of credit- Subject to the limitation of §904, [the tax impose
shall] be credited with the amounts provided in §901(b) plus, in the case of a
corporation, the taxes deemed to have been paid under §§902 and 960.
 (b) Amount allowed
 Subject to the limitation of § 904, the following amounts shall be allowed as
the credit under subsection (a):
 any income, war profits, and excess profits taxes paid or accrued [does not
include realty taxes] during the taxable year to any foreign country or to
any possession of the United States paid by
 (b1)- a U.S. Citizen or a U.S. Corporation
 (b3)- a resident alien
 Credit Limit
 §904(a)- a) Limitation- The total amount of the credit taken under section 901 (a)
shall not exceed
 [US pre-credit tax liability on foreign source income] the same proportion of
the tax against which such credit is taken which the TP’s taxable income from
foreign sources (but not in excess of the TP’s entire taxable income) bears to
his entire taxable income for the same taxable year.
 FTC < U.S. taxes paid (Foreign Source Income/ (FS Income+ USS
Income)
 FTC/U.S. Tx paid< FS/(FS+US)
 FTC< TX paid on Foreign Source Income
 FTC is not refundable
 §904(c)- Allows carryover and carryback. Taxes paid that exceed §904(a)
limit shall carryover first to the first preceding year and the remaining shall
carryback to the any of the first 10 succeeding taxable years
 §904(d)- Baskets- can only use passive FTC to offset passive FS Income and
can only use active FTC to offset active FS Income.
 §55 define credit for AMT
 §906(a)- A nonresident alien individual or a foreign corporation engaged in trade
or business within the United States get FTC for any ECI taxes paid to U.S. or
foreign country.

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  Policy Implications of Alternate Schemes
 Capital Export Neutrality (CEN)- company will be taxed the same regardless of
whether start new project domestically or foreign
 U.S. Corporation will pay the same amount of taxes for same project in the
United States as it would for the same project in Mexico
 Rationale for desire of CEN- want American companies to invest in the best
projects worldwide
 CEN is more important for efficiency
 Fully Refundable Tax Credit has CEN
 Capital Import Neutrality (CIN)- companies country of origin does not matter
if invest in same country.
 U.S. corporation or French Corporation will pay the same taxes if invest in
same Mexican Property
 Capital Ownership Neutrality (CON)- ownership of project is irrelevant to
tax consequences
 Rationale for desire to have CON- want person with best know how to
buy hotel
 Two Territorial Systems has CIN and CON
 National Neutrality- firm makes same decision as nation as a whole would make
(Nation as whole= money kept by firm+ money paid in US Taxes
 Foreign Tax Deduction has National Neutrality

Foreign Tax Deduction System

Nation as a Whole Preference (Π=profit, T=tax rate)
Baltimore Hotel Cancun Hotel
Firm’s Value Π- TU.S. Π Π- TU.S (Π- Nation as a
TMexΠ)- TMexΠ Whole Prefer
U.S. Fisc TU.S Π TU.S (Π- TMexΠ)- U.S. project by
Total Π Π-- TMexΠ TMexΠ
Firms Preference (Π=profit, T=tax rate)
Baltimore Hotel Cancun Hotel
Firm’s Value Π(1- TU.S.) Π- TU.S (Π- Firm prefer U.S.
TMexΠ)- TMexΠ project by FTMex)
(1- TU.S.)
(Π-FTMex)(1-
TU.S.)

 Example- U.S. Person runs Philly Hotel and makes $1M/ year. U.S. person is
deciding whether to run Cancun Hotel and make $1M/year or Baltimore hotel that
makes $1M/year
 Mexico has 20% or 70% Tax Rate. U.S. has 30% Tax rate.

System Mexico Taxes (20%/ U.S. Taxes (30%) Total Taxes

70%)
1) Mexican doesn’t $0 $300K (U.S. Hotel) $600K

24
tax. U.S. Tax +$300K (Mex Hotel)
Worldwide =$600K
$0 $600K (same above) $600K
2) Mex Territorial. $200K(Mex Hotel) $300K (U.S. Hotel) $800K
U.S. Tax Worldwide +$300K (Mex Hotel)
(double taxation) =$600K
$700K (Mex Hotel) $600K (same above) $1.3M
3) Mex Territorial. $200K(Mex Hotel) $300K (U.S. Hotel) $500K
U.S. Tax Territorial +$0K (Mex Hotel)
=$300K
$700K (Mex Hotel) $300K (same above) $1.0M
When both countries are territorial, have capital import neutrality, but lack capital export
neutrality
4) Mex Territorial. $200K(Mex Hotel) $600K (Precredit) $600K
U.S. Fully -$200K (Mex Tax)
Refundable =$400K (residual tax)
Unlimited Credit $700K (Mex Hotel) $600K (Precredit) $600K
System -$700K (Mex Tax)
= -$100K
With fully refundable FTC, have capital export neutrality, but lack capital import neutrality
5) Mex Territorial. $200K(Mex Hotel) $600K (Prededuction) $740K
U.S. Deduction -$200K*.3=$60K
System (like state =$540K
taxes) $700K (Mex Hotel) $600K (Prededuction) $1.09M
-$700K*.3=$210K
=$390K
Deduction system has national neutrality
6) Mex Territorial. $200K(Mex Hotel) $600K (Precredit) $600K
U.S. Non- -$200K (Mex Tax)
Refundable =$400K(residual tax)
Unlimited Credit $700K (Mex Hotel) $600K (Precredit) $700K
System -$600K (Credit Limit)
= $0K
Credit=[Lessor of
$600K or $700K]
4) Mex Territorial. $200K(Mex Hotel) $600K (Precredit) $600K
U.S. Non- -$200K (Mex Tax)
Refundable FTC =$400K (residual tax)
(U.S. System which $700K (Mex Hotel) $600K (Precredit) $1.0M
is a Hybrid System) -$300K (Credit Limit)
= $300K

[Credit Limit= (FS)/(USS+FS)*US Taxes on FS Income= $1M /$2M*$600K=$300K

Credit Limit= Lessor of ($300K or $700K)
Alternately, can think of two separate baskets, US Income and FS Income. FS FTC cannot be
used to offset US Income. Income from Philly Hotel is U.S. Income, can only use FTC to offset

25
U.S. Taxes on FS Income (Mexican Hotel). Note- don’t actually use basket model, use
proportion model

 Cross-Crediting
 Ex- Each country produce $1M income

Mex Taxes (70% Cayman Taxes (10% U.S. Taxes (30%) Net Taxes
Rate) Rate)
3 Projects- 1 in Mexico, 2 in U.S.
$700K X Precredit tax=$900K $1.3M
Credit= 1M/3M*
900K=$300K
-Credit lessor of
($300K or $700K)
$600K

3 Projects- 1 in each country

$700K $100K Precredit tax=$900K $1.1M
Credit= 2M/3M*
900K=$600K (raise
904a limit)
-Credit lessor of
($600K or $700K)
$300K
 International tax System- can always lessen taxes by changing jurisdiction.
 Here lower taxes because raises 904a limit and decrease taxes paid on third
project from $300K to $100K
 Deemed (Indirect) Tax Credit
 Applies to domestic corporation (not individuals) that are substantial holder (10% or
more) of foreign corporation that pay foreign tax. When the foreign corporation pays out
the dividend, domestic corporation will get a deemed tax credit in the same proportion as
they owns the foreign corporation.
 §902(a)- Deemed Tax Credit: a domestic corporation which owns 10 percent or more
of the voting stock of a foreign corporation from which it receives dividends in any
taxable year shall be deemed to have paid the same proportion of such foreign
corporation’s post-1986 foreign income taxes as—
 (1) the amount of such dividends (determined without regard to section 78), bears to
 (2) such foreign corporation’s post-1986 undistributed earnings.
 §902(c)- Undistributed earnings = amount of the earnings and profits of the
foreign corporation
 Purpose-
 Equalize branch and subsidiary treatment
 Stop level of tax for multilevel subsidiaries
 Corporation pays taxes when it brings money back to U.S. Corporation. Also, SH
pay capital gain and dividend taxes.

26
 §960(a)(1)- TP gets a deemed tax credit on the taxes paid wrt to §951 inclusions.
 A CFC’s earnings that were subject to tax under Subpart F are not taxed again when
distributed to the SH.
 Remember eligible for §951(a) inclusion if foreign tax rate <90% of maximum rate
(35%)
 Get deemed credit when subsidiary corporation pays taxes
 §960(a)(2)- Must deduct amount excluded from §959 when computing deemed tax
credit
 Dividends Received Deduction (doesn’t apply to foreign corporations.
 Intended- to prevent triple layer of tax
 §243- If a domestic corporation receives dividends from another corporation, it is
entitled to a deduction of 70 percent of the dividend it receives.
 If the domestic corporation owns 20% of more of the other corporation, it receives
an 80% deduction,
 The domestic corporation will get a 100% deduction for a qualifying dividend.
 §245- disallows dividend receive deduction for foreign corporation on foreign
sourced income. Only allow dividend received deduction on foreign corporation’s
U.S. Source income if the domestic corporation owns 10% of more of the foreign
corporation.
 §245(a) In the case of dividends received by a corporation from a qualified 10-
percent owned foreign corporation (if at least 10 percent of the stock of such
corporation (by vote and value) is owned by the TP), there shall be allowed as a
deduction an amount equal to the percent (specified in section 243 for the taxable
year) of the U.S.-source portion of such dividends (or ECI portions of income or
if foreign corporation pays the dividends on the day it is received)
 Ex- French tax rate- 20%, US tax rate- 35%. Entity makes $1M in France
 Scenario 1- U.S. Corporation conduct business in form of a trade or business in French
branch.
 French branch is disregarded entity, income goes straight to US Corp and then SH
pays taxes on dividend received
 Taxes-
 French Taxes
 US Corporation- 20% of $1M= $200K
 SH- 0
 US Taxes
 US. Corporation- FTC- $200K, 35% of $1M- FTC= $150K
 US SH- 35% of Dividend ($1M-taxes($350K)- 35% of $650K= $227.5K
 Total Taxes= $577.50K
 Scenario 2- U.S. Corporation conducts business in form of a trade or business in French
subsidiary. No Deemed tax credit
 Taxes
 France
 French Corporation- 20% of 1M- $200K
 U.S. Corporation (pay tax on dividend)- 15% (French withholding tax) of
$800K= $120K
 SH- 0
27
  U.S.
 French Corporation- 0
 U.S. Corporation- 35% of $800K -$120K [FTC]= $160K
 SH- 35% of ($800K-$120K-$160K)= $182K
 Total Tax= $662K
 Scenario 3- Scenario 2 with Deemed Tax Credit
 Taxes
 France
 French Corporation- 20% of 1M- $200K
 U.S. Corporation (pay tax on dividend)- 15% (French withholding tax) of
$800K= $120K
 SH- 0
 U.S.
 French Corporation- 0
 U.S. Corporation- 35% of $1M –$120K [FTC] -$200K [deemed FTC]= $30K
 Take 35% of $1M, not 35% of $800K b/c include dividend paid in France
in amount
 SH- 35% of ($800K-$200K-$120K-$30K)= $227.50K
 Total Tax= $557.50K (same as if foreign corporation was foreign branch)

Controlled Foreign Corporation (Foreign Sourced Income of

Foreign Subsidiary)
 Purpose: Prevent Deferrals
 Subpart F does not eliminate all deferral, but it makes it a lot harder for people to do.
 Corporations still get use deferral. Currently $2T of taxes are being deterred.
 Deferral (in Int’l Tax)- eliminating current tax by going to a low tax environment.
 Foreign corporation can benefit from unlimited IRA (in amount and in time- regular
IRA people cannot keep in forever)
 Foreign subsidiary will be taxed when money is repatriated, whenever that may be.
 If U.S. business operates branch in foreign jurisdiction that has no or little tax on
corporations, U.S. taxes corporation even if foreign sourced in many scenarios
 In U.S. law, residency of corporation is situs of incorporation- very malleable
 Without Subpart F, a foreign subsidiary in a foreign country performing
foreign sourced business would not be subject to U.S. taxes
 Foreign subsidiaries will eventually be taxed when money is repatriated back to U.S.
corporation
 Repatriation: Dividending money from foreign subsidiary to U.S. parent
 Currently U.S. owned foreign subsidiary are not repatriating because they are
waiting for the next repatriation tax holiday.
 Last tax holiday tax earning at 5.25% (better to get some then none)
 Most money from repatriation went to shareholders, not towards hiring
 Misconceptions about Repatriation

28
 Money is not abroad, money is located in the United States bank, it is
just in foreign incorporated subsidiary
 Not bad that money from repatriation went to SH
 Repatriation holiday did result in small bump in revenue, but also is
deterring other repatriation
 Knowledge of Repatriation is limited to about 8 corporation practices.
 Advantage of Deferral- no tax on investment earning build up (without build up, no
advantage of deferral
 The tax up front vs. tax at end does not make the difference.
 Ex- Invest Y dollars ($100). Rate of return=r=10%, tax rate=t=30%
 Money without IRA
 Investment= Y(1-T)= $100(70%)=$70 (post tax dollars)
 Earnings=Y(1-T)(R)= $70(10%)= $7
 Taxes on Investment Earning= Y(1-T)(R)T= $7(30%)=$2.10
 This is the major benefit of deferral, no tax on investment earnings
 After Tax Earning= Y(1-T)+ Y(1-T)(R)(1-T) = Y(1-T)(1+R(1-T))=$75
 Money in IRA after 1 year
 Investment-Y= $100 (pre-taxed)
 Earning- ry= 10%*$100
 Pretaxed dollars= Y+RY= Y(1+R)= $110
 Withholding tax = Y(1+R)T= $110*.3= $33
 After tax income= Y(1-T)(1+R)=$110(70%)=$77
 IRA= Y(1-T)(1-R) Non-IRA- Y(1-T)(1-R(1-T)) [difference highlighted]
 Who is a CFC?
 Subpart F - Controlled Foreign Corporations
 §951(a)(1)- If a foreign corporation is a controlled foreign corporation for an
uninterrupted period of 30 days or more during any taxable year,
 every person who is a United States shareholder of such corporation and who owns
stock in such corporation on the last day, in such year, on which such corporation is a
controlled foreign corporation
 shall [be taxed] on (A) sum of Subpart F income AND (B) §956 amounts
 [Subpart F is like partnership, income taxed when it is received, not when it is dividended
out]
 §951(b)- United States shareholder (USSH)=
 United States person (as defined in §957(c) [essentially the same as regular U.S.
person])
 who owns or is considered as owning
 10% or more of the total combined voting power of all classes of stock
entitled to vote of such foreign corporation.
 §957(a)- Controlled Foreign Corporation (CFC)=
 any foreign corporation if more than 50% of—
 (1) the total combined voting power of all classes of stock of such corporation
entitled to vote, OR
 (2) the total value of the stock of such corporation,

29
  is owned or is considered as owned
 by United States shareholders on any day during the taxable year of such
foreign corporation.
 Examples
 1) Foreign Corporation whose stock is own equally by 100 SH who are all U.S.
Citizens NO USSH (b/c no SH own >10% or more of voting power)NO CFC
 2) Foreign Corporation whose stock is owned 1/2 by 1SH and the other 1/2 by 6
SHs (all SHs are U.S. Citizens)
 Here the 50% SH is a USSH, while the 8.3% SH are not USSH. Here only
50% of foreign corporation owned by USSHnot CFC b/c not more than
50% owned by USSH
 3) Foreign Corp with 2 class of stock. D is a US person who own 60% of not-
voting stock. The rest of the stock is split evenly among 11 U.S. citizens.
 D is not USSH because does not own 10% or more of voting stock.
 Other 11 are not USSH b/c each own less than 10% of voting stockNo CFC
 4) Foreign Corp with 2 class of stock. E is a US person who own 60% of voting
stock. The rest of the stock is split evenly among 11 U.S. citizens.
 E is USSH, 11 others are not USSH.
 Since a USSH owns 60% of voting stock (or value)>50% CFC
 E is only USSH, so he is the only one who would be subject to Subpart F
taxes
 Ownership
 3 Types of Ownership:
 1) Direct Ownership- have title to stock §958(a)(1)
 2) Indirect Ownership- ownership through foreign corporation §958(a)(2)
 3) Constructive Ownership (“considered as owning”) §958(b)
 Indirect Ownership
 §958(a)(2)- Indirect Ownership- stock owned, directly or indirectly, by or for
a foreign corporation, foreign partnership, or foreign trust or foreign estate
shall be considered as being owned proportionately by its shareholders,
partners, or beneficiaries.
 Stock considered to be owned by a person by reason of the application of
the preceding sentence shall, for purposes of applying such sentence, be
treated as actually owned by such person.

 To do these types of problems, work through multiple corporate level from

bottom to top.
 Chain stops when it hits a domestic entity (§1.958-1(b)
 Ex (from §1.958-1(b))- U.S. Corp N wholly own U.S. Corp M. U.S. Corp
M owns 75% of foreign corp R, which owns 80% of foreign corp S,
which own 90% of foreign corp T.
 R is considered owning 72% of T (80%*90%)
 M is considered owning 54% of T (75%*80%*90%)
 Chain stops at M and does not continue to N b/c M is US Corp

30
 §958(b)- Constructive Ownership- start with rule §318 and modify
 §318 Constructive Ownership of Stock
 §318(a) Members of family- (1)(A) An individual shall be considered as
owning the stock owned, directly or indirectly, by or for—
 (i) his spouse (other than a spouse who is legally separated from the
individual under a decree of divorce or separate maintenance), and
 (ii) his children, grandchildren, and parents.
 AND By
 (1)(B)legally adopted children
 §958 Modification- §958(b)(1)- stocks owned by nonresident alien
family members will not be considered constructively owned
 §318(a)(2) Attribute FROM Entity TO Owner
 §318(a)(2)(A)-Partnerships and estates- Stock owned, directly or
indirectly, by or for a partnership or estate shall be considered as
owned proportionately by its partners or beneficiaries.
 §318(a)(2)(B)- Trust- Stock owned, directly or indirectly, by or for a
trust shall be considered as owned by its beneficiaries in proportion to
the actuarial interest of such beneficiaries in such trust
 §318(a)(2)(C)- Corporations- If 50 % or more in value of the stock
in a corporation is owned, directly or indirectly, by or for any person,
such person shall be considered as owning the stock owned, directly or
indirectly, by or for such corporation, in that proportion which the
value of the stock which such person so owns bears to the value of all
the stock in such corporation.
 §958 Modification- §958(b)(3)- 10%, not 50% trigger.
 §958 Modification- §958(b)(2)- if at least 50% ownership, stocks
owned by nonresident alien family members will not be considered
constructively owned, person considered owning entire entity.
 §318(a)(3) Attribute FROM Owner TO Entity
 §318(a)(2)(A) To partnerships and estates- Stock owned, directly or
indirectly, by or for a partner or a beneficiary of an estate shall be
considered as owned by the partnership or estate.
 §318(a)(2)(B) To trusts- Stock owned, directly or indirectly, by or for
a beneficiary of a trust shall be considered as owned by the trust
 §318(a)(2)(C) To corporations- If 50 % or more in value of the stock
in a corporation is owned, directly or indirectly, by or for any person,
such corporation shall be considered as owning the stock owned,
directly or indirectly, by or for such person.
 §958 Modification- §958(b)(4)- will not attribute ownership to non-
US person.
 §1.958-2(f)(iv)(2) Application- For every person, shall impute ownership
which is larger value as determined by indirect ownership or constructive
ownership
 Ex (Based off Example(1) in §1.958-2(f)(iv)(2)) - US A owns 5% and US
B owns 25% of Foreign Corp M. Foreign Corp M owns 60% of Foreign
Corp N.

31
 Indirect Constructive Maximum
A 5%*60%= 3% 10% trigger not 3%
pulled= 0%
B 25%*60%= 16% 25%*100%=25% 25% (>16%)

(since M own >50% N, M considered to constructively own 100% of N)

 Here, A is not USSH b/c 3%< 10%. Here, B is USSH b/c 25%> 10%
 Here, N or M is not CFC b/c USSH own<50% of (N or M)
 CFC Taxes
 §951(a) CFC Taxed on:
 §956 Amounts
 Subpart F Amounts
 §954(a) Foreign Based Company Income
 (1) the foreign personal holding company income (§954(c)
 (2) the foreign base company sales income (§954(d))
 (3) the foreign base company services income (§954(e))- IGNORE
 (5) the foreign base company oil related income (§954(g))-IGNORE
 Other
 Subpart F Income
 § 952(a) - Subpart F income defined=
 the sum of—
 (1) insurance income (as defined under §953),
 (2) the foreign base company income (as determined under § 954)
 (3) Etc.
 §952(b) Exclusion- Subpart F income does not include ECI Income
 §952(c) Limit- Subpart F income cannot exceed the earnings and profits [Net Income
after Distributions are paid] of such corporation for such taxable year
 This limit allows Subpart F to be limited by deductions that E&P are eligible for
 Subpart F Exceptions
 (1) High Foreign Taxes (>90% of 35% [maximum rate of tax specified in §11 (corporate
tax rates)])
 (2) ECI
 (3) Foreign Based Sales Income Exceptions
 Sale of Personal Property that has been substantially used
 Manufactured by CFC
 Same Country Use or Same Country Manufacturing
 (4) Foreign Based Personal Holding Company Income Exceptions
 Invest Actively in Business
 Same Country/ Pass Through Exception (really way of preventing double counting)
 Foreign Based Company Income
 §954(A) (a) Foreign base company income= the sum of—
 (1) the foreign personal holding company income (§954(c) reduced by §954(b)(5)),
 (2) the foreign base company sales income (§954(d) reduced by §954(b)(5))
 (3) the foreign base company services income (§954(e) reduced by §954(b)(5))

32
  (5) the foreign base company oil related income (§954(g) reduced by §954(b)(5)
 §954(d) foreign base company sales income

 §954(b)(5)- Deductions- Foreign Based Company Income shall be reduced, under

regulations prescribed by the Secretary so as to take into account deductions (including
taxes) properly allocable to such income.

 Foreign base company sales income

 Elements
 1) Resale- Buy low and Sell high
 2)Sale or Purchase from Related Party on One Side
 3) Personal Property
 4) Personal Property not manufactured in CFC’s country of incorporation
 5) Personal Property not used in CFC’s country of incorporation
 6) CFC is in low tax jurisdiction
 7) Mere touchdown- good may never arrive in country of CFC or if arrive, only
briefly
 Here is scenario where CFC choose to incorporate in low tax environment for
non-business reasons

 §954(d)(1) foreign base company sales income =

 (whether in the form of profits, commissions, fees, or otherwise)
 derived in connection with
 the purchase of personal property FROM a related person and its sale to any
person,
 the sale of personal property to any person on behalf of a related person,
 the purchase of personal property from any person and its sale TO a related
person, OR
 the purchase of personal property from any person on behalf of a related
person where—
 (A) the property which is purchased (or in the case of property sold on behalf of a
related person, the property which is sold) is manufactured, produced, grown, or
extracted outside the country under the laws of which the controlled foreign
corporation is created or organized, AND
 (B) the property is sold for use, consumption, or disposition outside such foreign
country, or, in the case of property purchased on behalf of a related person, is
purchased for use, consumption, or disposition outside such foreign country.
 Exceptions in Regulations §1.954-3
 1) Sale of Tangible Property-§1.954-3(a)(1)(i)[4th sentence] Sale of tangible
personal property will not be considered to be foreign base company sales income
if such property is sold to a person that is not a related person, after substantial
use has been made of the property by the controlled foreign corporation in its
trade or business.
 Ex- Loom purchased by related person that is used in T/B by CFC and then
sold to unrelated person
33
 ***2) Manufactured by CFC Exception--§1.954-3(a)(4)(i) Foreign base
company sales income does not include income of a controlled foreign
corporation derived in connection with the sale of personal property
manufactured, produced, or constructed by such corporation (as defined in this
regulation)
 §1.954-3(a)(4)(ii) Substantial transformation of property- If personal
property purchased by a foreign corporation is substantially transformed by
such foreign corporation prior to sale, the property sold by the selling
corporation is manufactured, produced, or constructed by such selling
corporation.
 Ex from Regs-
 Turning wood pulp into paper
 Turning steel rods into screws
 Turning Fresh Fish into Canned Fish
 §1.954-3(a)(4)(iii) Assembly of Parts- If purchased property is used as a
component part of personal property which is sold, the sale of the property
will be treated as the sale of a manufactured product, rather than the sale of
component parts, if the assembly or conversion of the component parts into
the final product by the selling corporation involves activities that are
substantial in nature and generally considered to constitute the manufacture,
production, or construction of property.
 20% Safe Harbor- the operations of the selling corporation in connection
with the use of the purchased property as a component part of the personal
property which is sold will be considered to constitute the manufacture of
a product if in connection with such property conversion costs (direct
labor and factory burden) of such corporation account for 20 percent or
more of the total cost of goods sold
 Ex from Regs
 Assembling an Automobile
 ***§1.954-3(a)(4)(iv) Substantial contribution to manufacturing of
personal property—
 (a) In general. If an item of personal property would be considered
manufactured, produced, or constructed prior to sale by the controlled
foreign corporation had all of the manufacturing, producing, and
constructing activities undertaken with respect to that property prior to
sale been undertaken by the controlled foreign corporation through the
activities of its employees, then this paragraph (a)(4)(iv) applies.
 (b) Activities. The determination of whether a controlled foreign
corporation makes a substantial contribution through the activities of its
employees to the manufacture, production, or construction of the personal
property sold involves, but will not necessarily be limited to, consideration
of the following activities:
 (1) Oversight and direction of the activities or process pursuant to
which the property is manufactured, produced, or constructed (under
the principles of paragraph (a)(4)(ii) or (a)(4)(iii) of this section).

34
  (2) Activities that are considered in, but that are insufficient to satisfy,
the tests provided in paragraphs (a)(4)(ii) and (a)(4)(iii) of this section.
 (3) Material selection, vendor selection, or control of the raw
materials, work-in-process or finished goods.
 (4) Management of manufacturing costs or capacities (for example,
managing the risk of loss, cost reduction or efficiency initiatives
associated with the manufacturing process, demand planning,
production scheduling, or hedging raw material costs).
 (5) Control of manufacturing related logistics.
 (6) Quality control (for example, sample testing or establishment of
quality control standards).
 (7) Developing, or directing the use or development of, product design
and design specifications, as well as trade secrets, technology, or other
intellectual property for the purpose of manufacturing, producing, or
constructing the personal property.
 Ex Apple- Manufactured in China, product sold for use outside
Ireland. CFC in Ireland does oversee, quality control qualify for
CFC exemption.

 Foreign Personal Holding Company Income

 Misnomer, Think of as “Passive Income”
 §954(c)(1) Foreign personal holding company income= the portion of the gross
income which consists of:
 (A) Dividends,
 interest,
 royalties,
 rents, and
 annuities;
 (C)-(G) Equivalents of Dividends, Interest, Rents and Annuities;
 (B) Gains from sales of Non-Inventory Property (ex- Stocks/Pship Interests)
 (H) Personal Service Contracts
 Prevents US individual A from creating Corporate C in low tax environment
and having Corporation C paid by hiring Corporation in Country X instead of
paying US Person A directly
 Exceptions
 §954(c)(2) Seem like Passive but Actually T/B
 (A) Gains from inventory property sales
 (A) Rent/Royalties in Act of conduct of current business unless received by
(3) related person
 (B) Active Financing from Qualified Banking Corporation
 §954(c)(3)-Same Country Exception (subsumed by Look-Thru Exception)- Don’t
include rent, royalties, dividends, etc. from Related Person in Foreign Personal
Holding Company Income for transactions between related persons in which both
corporations are organized in same foreign country (Important for Double Irish
Sandwich)

35
  §954(c)(6) Look-Thru Exception- Don’t include rent, royalties, dividends, etc.
from Related Person in Foreign Personal Holding Company Income for
transactions between related persons
 This is temporary Statute that keeps on getting renewed
 Ex- Apple Ireland 1 (top slice) wholly own Apple Ireland 2 (bottom slice). Apple
Ireland sales to distributor at France at high price and buys IP license fees from Apple
Ireland 1.
 License Fees are potentially subpart F income but they are caught in look-thru
exception and the same country exception
 Alternate- Hybrid Entity- Apple Inc. can treat bottom slice as not separate from
U.S. Corporation, as branch to Apple HQ

 956 Amounts
 Key Definition- U.S. Property
 U.S. Property essentially only includes stock of parent or loan to parent
 §956(c)(1)- U.S. Property= any property which is—
 (A) tangible property located in the United States;
 (B) stock of a domestic corporation[with major exception 2[F];
 (C) an obligation of a United States person[with major exception 2[A, D-F];
 OR (D) any [IP] right to the use in the United States of—,
 which is acquired or developed by the CFC for use in the U.S.9
 §956(c)(2) Exceptions
 (A) United States treasuries, money, or deposits with any banks or corporation
 (B) property located in the United States which is purchased for export to, or
use in, foreign countries;
 (C) [account receivables, trade receivables];
 ** (F) the stock or obligations of a domestic corporation which is neither a
 USSH of the CFC, nor
 a domestic corporation, 25% or > total combined voting power of which,
is owned, or is considered as being owned, by such USSHs in the
aggregate
 (L) an obligation of a United States person which—
 (i) is not a domestic corporation, and
 (ii) is not a USSH of CFC or related party
 §956 Amounts is lessor of (US Property- E&P) and (E&P from this year)
 956(a) “956 Amounts” = the lesser of—
 (1) the excess (if any) of—
 (A) [USSH US Property * proportion of year in which USSH was a SH] such
shareholder’s pro rata share of the average of the amounts of United States
property held (directly or indirectly) by the CFC, OVER
 (B) [amount of USSH Property already considered in last year’s tax return] the
amount of earnings and profits described in section 959 (c)(1)(A) with respect to
such shareholder, or
 (2) such shareholder’s pro rata share of the applicable earnings of such CFC
 §956(b)(1)- “applicable earnings” =

36
  (A) the amount (not including a deficit) referred to in §316 (a)(1) [Earnings &
Profits from this year’s minus Earning and Profits of Prior Years] PLUS
 (B) the amount referred to in section 316 (a)(2) [Earning & Profit from this year],
 MINUS distributions made during the taxable year
 AND MINUS by earnings and profits described in §959 (c)(1) [Earning & Profits
from prior years AND Duplication in Subpart F Income].

 Prevents Double Counting

 §959- Excludes Subpart F income from E&P that was counted to compute 956
Amounts
 §961(a)- §951 inclusion increase basis (so not taxed again on that income is
distributed as dividend or capital gain)
 §961(a)- Increase in Basis- the basis of a USSH’s stock in a CFC be increased
by the [amount of §951(a) inclusions] [Remember §951(a) includes 956 amounts
and Subpart F income] BUT only to the extent to which such amount was
included in the gross income of the USSH
 §961(b)- Reduce Basis when income that was taxed by §951 is distributed to USSH
 §961(b)- Reduction in Basis -the adjusted basis of stock or other property wrt
which a USSH or a United States person receives an amount which is excluded
from gross income under §959(a) shall be reduced by the amount so excluded.
 Receive= Only actual receipt, not constructive receipt
 For constructive receipt, money is still in CFC and still would be A/R

 §1248- Capital GainsDividends

 Converts Capital Gains into Dividends
 Policy- Good for Corporations, Bad for Individuals
 Individual
 Dividend Rate on Qualified Dividend= Same rate as Long-Term Capital Gains
 §1(h)(11)Qualified if (1) U.S. Corporation or if (2) Foreign Corporation
eligible for benefits of a comprehensive income tax treaty or with stock
readily tradable on U.S. securities market
 Dividend Rate on Non-Qualified dividend- 39.6% plus Net Investment
Income Tax of 3.8%
 Long-Term Capital Gains Rate- 20% plus 3.8%
 Ex- Individual own CFC wholly which he contributed $1M to. He made $2M
of real income and $2M of subpart F Income over 2 years
 Without §1248- He would be subject to a gain of $2M+ FV
 Amount Realized= $5M (nothing was distributed) + future value
 Basis=$1M initially contributed +$2M subpart F income (§961)
 Total Taxes= $476K
 With §1248- $2M gain converted to dividend
 Here, since wholly owned, foreign corporation stocks are not readily
tradable and since CFC is in tax haven, it is not subject to tax
treatynon-qualified (rate is 43.6%)
 Total Taxes= $868K
 Corporation

37
  Corporation has no preferential rates. All income, including capital gains and
dividends are subject to 35% rate. Wrt rate, corporation indifferent between
capital gains and dividends
 However, Domestic Corporations are eligible for dividend received deduction
for dividends paid by domestic corporations.
 For dividends paid by foreign corporation to domestic corporation, domestic
corporation eligible for deemed FTC (individuals are not eligible for deemed
FTC)
 Corporations are also subject to capital loss limits (where only can carry
forward for five years)
 §1248(a)- If
 (1) a U.S. person sells or exchanges stock in a foreign corporation, AND
 (2) such person is a USSH (owns10% of more of voting power) at any time
during the 5-year period ending on the date of the sale or exchange when such
foreign corp was a CFC
 then the gain recognized on the sale or exchange of such stock shall be included
in the gross income of such person as a dividend, to the extent of the E&P of the
foreign corp attributable to such stock which were accumulated during the period
or periods the stock sold or exchanged was held by such person while such
foreign corp was a CFC.
 Note on Dividends- SH value in corporation has three components- (1) SH Basis in
her Shares (2) E&P- important to keep track (3) Future E&P of corporation
 E&P is amount not yet distributed out
 Rule- If it is conceivable that distribution came out of E&P treat as dividends
 First take money out from E&P, then take money out from basis, then
remainder is future E&P
 §1248(d)- Only convert capital gains attributable to “Adjusted E&P” into dividends
 Adjusted E&P- Total E&P Minus (E&P attributable to any amount previously
included in the gross income under §951, wrt the stock sold or exchanged, but
only to the extent such amount did not result in an §959 exclusion).
 §959(a) Exclusions includes Actual Distribution and 956 amounts
 For Actual Distributions, already subtracted from E&P, do not want to
subtract again
 956 amounts- also would be double counted.
 Since Constructive Distributions does not actually get distributed before
sale/exchange like actual distributions, do not have to subtract amount from
E&P.
 §959(d)- Distributions excluded from gross income not to be treated as
dividends- any distribution excluded from gross income under §959(a) [actual
distributions and §956 amounts] shall be treated as a distribution which is not
a dividend; except that such distributions shall immediately reduce earnings
and profits.
 Should treat §959a exclusions as a reduction in principal- Decrease Basis
 Notice- 2004-70 §2.04- Dividends received by CFC and FPHC does not receive
preferential rate

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  A foreign corporation may be both an FPHC and a CFC. Because a foreign
corporation that is both an FPHC and a CFC continues to be an FPHC, any
dividends (both actual dividends and amounts treated as a dividend) received by
an individual shareholder from that corporation are not qualified dividend income

Passive Foreign Investment Company

 Who is a PFIC?
 CFC Subpart F regulations only effect USSH and CFC.
 Many non-controlled SH still get deferral
 Passive Foreign Investment Company (PFIC) are also target to anti-deferral regulations
 §1297(a)- “Passive foreign investment company”=any foreign corporation if—
 (1) =>75% of gross income of such corp for the taxable year is passive income, OR
 (2) =>50% of assets held by such corp during the taxable year produce passive
income or which are held for the production of passive income
 §1297(e) % Assets is determine by adjusted bases
 §1297(b)- “passive income” defined in §954(c) [§ that defines FPHC income]
 §954(c)- includes (1)(a) Dividends, interest, royalties (not from T/B), rents, and
annuities AND (1)(b) gains from sale of property AND (1)(H) Personal Service
Contracts, etc.
 §1297(b) Exceptions- active banking business and insurance business, etc.
 §1297(c)- Look-Thru Rule if PFIC own at least 25 percent (by value) of the stock of
another corporation, then the PFIC shall be treated as holding proportion shares of asset
and income from the other corporation
 §1297(d)- PFIC rules are subordinated to CFC Rules.
 a corporation shall not be treated wrt a SH as a PFIC during the qualified portion
(portion of the SH’s holding period during which the SH is a USSH of a CFC) of
such SH’s holding period with respect to stock in such corporation (§n.
 §951(c)- If an amount would be included in the gross income of a United States
shareholder for any taxable year both CFC and PFIC, such amount shall be included
in the gross income of such shareholder only under CFC Regime.
 How are PFIC taxed? (3 regimes)
 Note- Once PFIC, all PFIC income will be taxed under Regime
 1) Default Rule (§1291 Regime)
 Basic Idea- When U.S. person receive certain distributions (excess distributions), it
will be taxed on distribution plus interest on delay.
 Divide the excess distribution between the years in the holding period. For each
previous year multiply the excess distribution by compounded interest AND tax at
highest applicable ordinary income rate (39.6% for individuals, 35% for
corporations)

Excess Distributions(ED ) ED ED
Taxes=MaxTR + MaxTR ( 1+interest rate )+ MaxTR ( 1+interest rat
Years∈Holding Period( N ) N N
 MaxTR=Maximum Tax Rate on Ordinary Income (39.6% for individuals,
35% for corporations)
 Interest Rate=Rounded Federal Short Term Interest Rate+3 %

39
  Currently Federal Short Term Interest Rate is 0.25%, which rounds down
to 0, so interest rate in these calculations are 3%
 §1291(a)(1)(A)- the amount of the excess distribution shall be allocated ratably to
each day in the TP’s holding period for the stock
 §1291(a)(1)(B) At distribution, US person gross income includes
 the amount of the excess distribution shall for
 (B) (i) the current year, or
 (B) (ii) any period in the TP’s holding period before the 1st day
 AND (C) the tax imposed by this chapter for the current year shall be increased
by the deferred tax amount.
 §1291(b)(2)(A) “Total Excess distribution”= (Current Distribution) - (1.25 x
average distribution of last 3 years)
 Total Excess distribution is the excess (if any) of—
 (i) the amount of the distributions in respect of the stock received by the TP
during the taxable year, OVER
 (ii) 125 percent of the average amount received in respect of such stock by the TP
during the 3 preceding taxable years (or, if shorter, the portion of the TP’s holding
period before the taxable year).
 §1291(a)(3)(A)- Use Holding Period defined in §1223 (begin on date of acquisition,
end on date of distribution).
 For §1296 (mark-to market) The TP’s holding period ends on the date of such
distribution, and begins on the first day of the first taxable year beginning after
the last taxable year.
 §1291(b)(3)(A) determinations shall be made on a share-by-share basis, except that
shares with the same holding period may be aggregated
 §1291(c)(1)- “deferred tax amount” means, wrt any distribution or disposition to
which subsection (a) applies, an amount equal to the sum of—
 (A) the “aggregate increases” in taxes + (B) the aggregate amount of interest
 §1291(c)(2)- Aggregate increases in taxes shall be determined by multiplying each
[excess distribution allocated] to [each] taxable year by the highest rate of tax in
effect for such taxable year under §1 [individual ordinary income tax- 39.6%] or §11
[corporation ordinary income tax- 35%], whichever applies.
 §1291(c)(3)(A)- interest rates defined in §6621 same as those who underpay taxes
 §6621(a) - Interest Rate= (A) the Federal short-term rate , plus (B) 3% (or 2 % in
the case of a corporation).
 §1297(D)(1) (c)- Federal short-term rate- §1297(c)- The Federal short-term
rate shall be the rate determined based on the average market yield on
outstanding marketable obligations of the United States with remaining
periods to maturity of 3 years or less.
 2) § 1293 Election (Qualified Election Fund)
 Charge tax when corporation earns it (pass-thru straight to TP (like Pship) even
though TP doesn’t literally have possession of earning (no actual distribution)
 §1293(a) Inclusion- (1) Every US person who owns (or constructively own under
§1298(a)) stock of a qualified electing fund at any time during the taxable year of
such fund shall include in gross income—

40
  (A) as ordinary income, such shareholder’s pro rata share of the ordinary earnings
of such fund for such year, and
 (B) as long-term capital gain, such shareholder’s pro rata share of the net capital
gain of such fund for such year.
 §1293(d)- Basis adjustments- The basis of the TP’s stock in a PFIC shall be—
 (1) increased by any amount which is included in the income of the TP under
§1293(a) wrt such stock, and
 (2) decreased by any amount distributed wrt such stock
 Basis Adjustment Prevents Double Tax
 3) §1296 Mark-to-Market
 (a) For marketable securities, use the FMV of the stock on the last day of the year to
determine taxable gain during the year. Include amount as ordinary income.
 §1291(a)(3)(A)- For §1296 (mark-to market) The TP’s holding period ends on the
date of such distribution, and begins on the first day of the first taxable year
beginning after the last taxable year
 (b) Adjust basis to reflect last year’s last day of the year FMV, decrease basis when
distribute out.
 These three methods are regimes which can be used for corporate reform to get rid of the
second layer of corporate tax.

Transfer Pricing (§482 and Regs)

 IRS means of pricing good/services between two related parties that are not dealing in an
arm’s length transaction
 Pricing decision can maximize income allocated to low tax environments (such as
Ireland)
 IRS has an extremely difficult time of determining transfer pricing for intangibles (brand
names/ technologies)
 Cost-Sharing Arrangements such as arrangement between Apple Ireland and Apple
US where Ireland contribute cash to the JV and US contribute intangibles.
 Example- COGS=$50, Retail Price=$100, Arms Length’s Price=$75
 Outbound Examples
 1) U.S. Corporate sell product for use in Country X at $100, Country X has no taxes
 US Taxation- since U.S. person, taxed on all profit worldwide (all $50), not
eligible for tax credit b/c Country X has no taxes.
 Sourced based on 50-50 Production-Sales Allocation (Sale is 100% in
Country X, Production 100% US)
 Foreign Taxation- $0. If Country X mirrored US laws, will be ECI if have T/B
(and need permanent establishment for treaty)- since active, not withholding tax
 2) U.S. Corporation Sells to wholly own Xish subsidiary at $75.
 Current Taxation
 Foreign Taxation=$0
 U.S. Taxation on $25
 No Subpart F taxation on US Corp for subsidiary income because falls under
same country use exception for FBC sale income.
 Later Taxation
41
  $25 from Sub X when repatriated back to U.S. (deferral- build-up is tax-free)
 3) U.S. Corporation Sells to wholly own Xish subsidiary at $51
 Current taxation= $1
 Deferred Taxation=$49 (Transfer Pricing “turbo-charges” tax benefits of deferral)
 Inbound Examples
 1) Foreign Corp (incorporated in Country Y) Sells product in US
 US taxation- no withholding tax b/c not passive. ECI on US source income fi
have T/B in US.
 Sourced based on 50-50 Production-Sales Allocation (Sale is 100% in
Country X, Production 100% US). Tax on $25.
 FTC does apply to FTC §906 but only to proportional allocation based on FS
component
 2) Foreign Corp sells to Foreign Corp X Subsidiary (incorporated in Country X) for
$51 which sells to a U.S. Subsidiary of Foreign Corp X for $99.
 Tax on $1, No Subpart F income b/c No USSH unless Country Y has mirroring
tax provision to U.S.
 §482 meant to guide IRS on how to write tax regulations.
 §482- In case of 2+ organizations, trades, or businesses owned or controlled directly
or indirectly by the same interests, the Secretary may distribute, apportion, or allocate
gross income, deductions, credits, or allowances between or among such
organizations, trades, or businesses, if he determines that such distribution,
apportionment, or allocation is necessary in order to prevent evasion of taxes or
clearly to reflect the income of any of such organizations, trades, or businesses.
 In the case of any transfer (or license) of intangible property (within the meaning of
section 936 (h)(3)(B)), the income wrt such transfer or license shall be commensurate
with the income attributable to the intangible.
 §482 is general provision and does not just apply in international tax realm
 §482 clause regarding intangibles is retrospective
 General Rules
 1.482-1(a)
 The purpose of §482 is to ensure that TPs clearly reflect income attributable to
controlled transactions and to prevent the avoidance of taxes wrt such transactions.
§482 places a controlled TP on a tax parity with an uncontrolled TP by determining
the true taxable income of the controlled TP.
 Outline-
 §1.482-1sets forth general principles and guidelines to be followed
 §1.482-2 provides rules for the determination of the true taxable income of
controlled TPs in specific situations, including controlled transactions involving
loans or advances or the use of tangible property.
 §§1.482-3-6 provide rules for the determination of the true taxable income of
controlled TPs in cases involving the transfer of property.
 §1.482-7T sets forth the cost sharing provisions.
 §1.482-8 provides examples of the best method rule.

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  § 1.482-9 provides rules for the determination of the true taxable income of
controlled TPs in cases involving the performance of services.
 1.482-1(b)(1) Arm’s Length Standard
 In determining the true taxable income of a controlled TP, the standard to be applied
in every case is that of a TP dealing at arm's length with an uncontrolled TP.
 A controlled transaction meets the arm's length standard if the results of the
transaction are consistent with the results that would have been realized if
uncontrolled TPs had engaged in the same transaction under the same
circumstances (arm's length result). However, b/c identical transactions can rarely
be located, whether a transaction produces an arm's length result generally will be
determined by reference to the results of comparable transactions under
comparable circumstances.
 §1.482-1(i)(5) Controlled TP = any TPs owned or controlled directly or
indirectly by the same interests, and includes the TP that owns or controls the
other TPs. [Rule of thumb- 50% or more interest]
 Uncontrolled TP means TPs not owned or controlled by the same interests.
 §1.482-1(e)- Arm’s length Range- must use various comparable controlled
transactions (with reasonable adjustments to improve estimates) to get range of
estimates. From the possible estimates, must choose an estimate in the interquartile
range (the middle two quartiles)
 1.482-1(c)(1) Best method rule. The arm's length result of a controlled transaction must
be determined under the method that, under the facts and circumstances, provides the
most reliable measure of an arm's length result. [No TP election]
 Reasonable Method is not enough, must be best method
 (2) The two primary factors to take into account are the degree of comparability
between the controlled transaction (or TP) and any uncontrolled comparables, AND
the quality of the data and assumptions used in the analysis.
 §1.482-1(d) Comparability Factors
 (i) Functions;
 (ii) Contractual terms;
 (iii) Risks;
 (iv) Economic conditions; AND
 (v) Property or services.
 Methods produce uncertain results. As a result IRS and big corporation come to
Advance Pricing Arrangements Agreements that are not public.
 Separate Entity vs. Formulary Apportionment
 Federal Rules and OECD use Separate Entity Approach, respect corporate boundaries
 States use formulary apportionment that general use three factors (where property
located, where payroll located, where sale located) separate or in combination.
 Ex- if 3/4 of sales are in country X, apportion 3/4 of sale income to Country X
subsidiary
 OECD proposed reform to push to formulary apportionment
 Tangible Property- 3 Methods for Determining Transfer Pricing
 Comparable Uncontrolled Price Method §1.482-3(b) [Default/Preferred]

43
  (1) The comparable uncontrolled price method evaluates whether the amount charged
in a controlled transaction is arm's length by reference to the amount charged in a
comparable uncontrolled transaction.
 (2) Ex 1- USM, a U.S. manufacturer, sells the same product to both controlled
and uncontrolled distributors with the same terms except the controlled distributor
price include transportation and insurance cost.
 Since transportation and insurance cost can be ascertainable and no other
material difference exist, can use this method to determine arm length pricing
 Resale Price Method §1.482-3(c)
 [Determine wholesale price from retail profit and retail price]
 (1) The resale price method evaluates whether the amount charged in a controlled
transaction is arm's length by reference to the gross profit margin realized in
comparable uncontrolled transactions.
 GPM= (selling price-unit cost)/selling price. Know GPM and selling price, solve
for unit cost.
 The resale price method measures the value of functions performed, and is ordinarily
used in cases involving the purchase and resale of tangible property in which the
reseller has not added substantial value to the tangible goods by physically altering
the goods before resale.
 For this purpose, packaging, repackaging, labelling, or minor assembly do not
ordinarily constitute physical alteration. Further the resale price method is not
ordinarily used in cases where the controlled TP uses its intangible property to
add substantial value to the tangible goods.
 Cost Plus Method §1.482-3(d)
 [Determine wholesale price from cost of production]
 The cost plus method evaluates whether the amount charged in a controlled
transaction is arm's length by reference to the gross profit markup realized in
comparable uncontrolled transactions.
 GPM=(wholesale price- unit cost)/wholesale price. Know unit cost and GPM,
solve for wholesale price
 The cost plus method is ordinarily used in cases involving the manufacture, assembly,
or other production of goods that are sold to related parties.
 Intangible Property
 Very Difficult for IRS to compute transfer pricing
 §1.482-4 For all intangible property except cost sharing arrangements §1.482-4(g)
 §1.482-7 For Cost Sharing Arrangements

 §1.482-4 Intangible Property [Not Cost-Sharing]

 §1.482-4(a)- Must use principles from §1.482-1 [Best Method, Comparability, Arm’s
Length Range, Periodic Adjustment]
 §1.482-4(b)- Intangible= Patents, (inventions, formulae, processes, designs, patterns,
or know-how); Copyrights and literary, musical, or artistic compositions;
Trademarks, trade names, or brand names; Franchises, licenses, or contracts;
Methods, programs, systems, procedures, campaigns, surveys, studies, forecasts,
estimates, customer lists, or technical data; and Other similar items.

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  [Apply to both licensing and sales]
 Three Methods for Calculating Transfer Pricing
 (1) CUT- Comparable Uncontrolled Transactions
 (2) CPM- Comparable Profit Methods
 (3) Profit Split Methods
 (a) Comparable Profit Split Methods
 (b) Residual Profit Split Method
 (1) §1.482-4(c)- CUT- Comparable Uncontrolled Transactions
 [Similar to Comparable Uncontrolled Pricing Method]- evaluates whether the
amount charged for a controlled transfer of intangible property was arm's
length by reference to the amount charged in a comparable uncontrolled
transaction
 §1.482-4(c)(2)(iii)(B)- Factors
 (i) Be used in connection with similar products or processes within the
same general industry or market; AND
 (ii) Have similar profit potential [net PV of the benefits to be realized
through the use or subsequent transfer of the intangible, considering
the capital investment and start-up expenses required, the risks to be
assumed, and other relevant considerations]
 (2) §1.482-5- CPM- Comparable Profit Methods
 [Determine Arm’s Length Transaction by splitting cost based on profitability
of various competitors] [Similar to Resale-Price, Cost Plus Methods]
 (a) arm's length based on objective measures of profitability (profit level
indicators) derived from uncontrolled TPs that engage in similar business
activities under similar circumstances.
 (b1) the Assign determination of an arm's length result is based on the amount
of operating profit that the tested party would have earned on related party
transactions if its profit level indicator were equal to that of an uncontrolled
comparable
 (b2) Tested Party- the controlled participant with more verifiable data
 (b4) Objective measures of profitability
 Operating profits
 Rate or return on capital employed
 Financial ratios
 Other
 (3) §1.482-6- Profits Split Method
 Know how much total group makes, know how much each party contributed
in value. From that determine % of value that is attributed to each controlled
TP (based on functions performed, risks assumed and resources employed).
 §1.482-6(c)(2). Comparable Profit Split Method- Multiply percentage of
profit that is attributable to each controlled TP by the total profit group
made to determine each uncontrolled TP income
 §1.482-6(c)(3). Residual Profit Split Method- assigns each uncontrolled
TP the normal amount of market return that the average company in the
industry makes. The amount that the controlled TP makes that is above the

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 average industry profit return is called the residual. Split the residual profit
between the two uncontrolled TP based on % of value that each attributed.
 Is Intangible Profit really retrospective (determine transfer price based on past data)
 § 1.482-4(f)(2)- calls for periodic adjustments on an annual basis but set of
circumstances where don’t have to make annual adjustments

 §1.482-7 Cost-Sharing Arrangements

 General idea- IrishSub and USCo form a joint venture (contract) that both would
contribute to development of IP (in reality only USCo contribute to development and
IrishSub contribute cash). In return for mutual contributions, they divvy up the world
in territory where each would have exclusive right to sell new IP. USCo also
contributes pre-existing platform (and IrishSub contribute cash (the pre-existing
platform is undervalued)) which new IP would expand upon.
 Pre-existing platform is very difficult to price
 Can claim has high value b/c w/o it, new platform is impossible
 Can also claim have very little value b/c now obsolete due to new platform
 This can be thought of as a transaction where each trade 1/2 non money asset for
use of 1/2 non money asset and cash

 Two Components
 (1) §1.482-7(b) Cost-Sharing Transaction
 A cost sharing arrangement is an arrangement by which controlled
participants share the costs and risks of developing cost shared intangibles in
proportion to their RAB shares
 (2) §1.482-7(c) Platform Contributing Transactions
 A platform contribution is any resource, capability, or right that a controlled
participant has developed, maintained, or acquired externally to the intangible
development activity (whether prior to or during the course of the CSA) that is
reasonably anticipated to contribute to developing cost shared intangibles.
 Requirement for Cost-Sharing Transactions
 RAB- Reasonably Anticipated Benefits- must pay out based on percentage of
effort contributed
 Each partner engaged in PCT (Platform contributing transaction)
 Non-overlapping territorial divide (time divide not sufficient)
 Best Method for determining value of Platform Contribution
 ((i) CUT- comparable uncontrolled transaction method described in § 1.482-4(c),
as described in (g)(3);
 (ii) The income method, (g)(4);
 Allocate price based on PV of best realistic alternative to cost sharing
arrangement such as licensing out platform.
 (iii) The acquisition price method, (g)(5);
 Determine price of platform contribution by using the theoretical acquisition
price of a company whose sole asset is the platform
 (iv) The market capitalization method, (g)(6);

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  Determine price in reference to stock price of a uncontrolled TP who just
owned the platform contribution
 (v) The residual profit split method, (g)(7); and
 Same as §1.482-6(c)(3) for intangibles.
 (vi) Unspecified methods, (g)(8) of this section.

Policy and Real-World Applications

 Old Structure
 Domestic Company sells software at low cost to foreign subsidiary in Bermuda (0%
corporate tax), which in turns sells software at high cost in Europe and Middle East
 Despite Bermuda being a foreign corporation (incorporated in Bermuda) with foreign
source income (source of sale of IP= source of end user= Europe/Middle East),
foreign corporation will be subject to Subpart F income
 Subpart F income
 No Foreign Personal Holding Company Income since it is not a license, income is
not royalty or fee
 There will be foreign based company sales income, so will be tax immediately
 Are there any exceptions applicable?
 Same Country Use Exception- not applicable
 Same Country Manufacturer Exception/ Same Country Own Exception-
Printing label on CD is probably not enough.
 Maybe substantial contribution exception from newer regulations may
shield this income
 US will also tax eventual dividends and price of software sold to Foreign corporation
(transfer pricing might adjust artificially low price).
 Double Irish Sandwich for Megasoft (Darby & Lemaster)
 Advantages of Ireland
 Low 12.5% tax
 Lenient Transfer Pricing Rules
 Different Residency Regime than U.S.
 Other
 Note- If crack down on Ireland, another country will take its place
 Scenario- Domestic Corporation own Sub 1 in Ireland which owns Sub 2 in Ireland,
which own Sub 3 in country of sale (France).
 US and Sub1 enters into a CSA (Cost-Sharing Arrangement) where get undervalued
platform and right to sell it in Europe and Middle East. In return, Sub 1 pays cash.
Sub 1 licenses software to Sub 2 at artificially high price. Sub 2 imprints CD. Sub 2
sell CDs to Sub 3, which sells in local country
 Round-Tripping- Sub1 could theoretically bargain for right to sell in Europe, Middle
East and U.S. Many companies do that. Unclear why they didn’t (maybe hogs get
slaughtered, maybe U.S. Sourced income will create other problems)
 Residence/ Source
 Sub 1- US will not see it as an US corporation because not incorporated in US.

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  For corporate law purposes, Irish law sees corporation as Irish Corporation
 For Irish law, in order to be foreign corporation, need to manage/control not in
Ireland, need to own active business in Ireland (Sub 2) and country that
manage and control must have tax treaty with Ireland.
 Thus for Irish tax purposes, Sub 1 is a Bermudian corporation
 Sub 2- US will not see it as an US corporation because not incorporated in US.
 US will not even see it as a separate Irish corporation for Sub 1 because it
checked the box for U.S. tax purposes to be a disregarded entity
 Note- some corporation such as Irish Public Limited Corporation are not
able to check-the-box, they are automatically corporation, but there are
other types of Irish corporations
 Ireland see Sub 2 as Irish corporation doing business in Ireland
 Hybrid Entity- Seen as separate organization for Irish purposes, not for U.S.
purposes
 Sub 3- France Corporation with French Source Income
 Taxes
 U.S. Taxes
 Domestic Corporation
 §367- requires domestic company to recognize income from transfer of IP
to any foreign corporationdeems transfer as a sale
 Cost Sharing Arrangements makes §367 non applicable
 Corporation will pay taxes from Income from U.S. Sales because they did
not round trip
 Corporation will pay taxes for payments Sub1 made in CSA
 Corporation will pay taxes for eventual dividends made from foreign
subsidiary, unless another repatriation holiday like in 2005
 Sub 1 and Sub 2
 Both are seen as same foreign person with foreign sourced income, no
U.S. tax
 Sub 3- Foreign person, foreign source income, not taxed
 Subpart F Income
 Sub 1 (Bulk of income is licensing)
 Not foreign based personal holding company income because simply
payment between corporation and branch. Also, not a license, income
is not royalty or fee
 No foreign based sale income because manufactures product in Ireland
(substantial contribution exception). Look-thru rule and same country
exception may also be applicable
 Sub 2 (Bulk of Income from Resale)
 Hybrid Structure prevent U.S. Tax
 Own Manufacturer Exception (substantial contribution exception)
 Irish Taxes
 Sub 1 considered foreign person (Bermudian)- license income- not taxed
 No ECI b/c no trade or business in Ireland
 No withholding tax because there is no Irish withholding tax on copyrights

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  Ireland does have withholding tax on patents. To get around that, Create
Dutch Subsidiary.
 Dutch has no withholding tax on patents (wrt Bermuda)
 EU has treaty that has no withholding tax between any EU country
 Sub 2- Income is difference between license fee and sale price to Sub 3. That
will be taxed at 12.5%, but since price purchase from Sub 1 is artificially
inflated and Ireland has weak transfer pricing regime, little income to pay tax
on.
 Bermuda- No Corporate Tax
 France- will tax Sub 3 on retail sales but since purchase item at artificially high
price from Sub 2, very little income to pay tax on.

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