Chapter 4 Federal International Taxation

Contents:

4.1 Introduction
4.2 Tax Treaties
4.3 Foreign Tax Credit
4.4 Source of Income and Deductions
4.5 Transfer Pricing
4.6 Tax Havens and Subpart F
4.7 US Possessions Corporations
4.8 Out-Bound Transfers
4.9 Export Sales Incentives
4.10 US Branches of Foreign Corporations
4.11 US Dollars and Other Currencies

4.1 Introduction

a. Nature and Limitations of the US Taxing Jurisdiction

b. US Taxing Jurisdiction of US Corporations
c. US Taxing Jurisdiction of Foreign Corporations
d. US Indirect Taxing Jurisdiction

a. Nature and Limitations of the US Taxing Jurisdiction

There is a significant difference between the nature of the taxing

jurisdiction of the United States (US) and that of the state of
California. For multi-jurisdictional corporate business enterprises,
California may only tax that income derived from, or attributable to,
California sources. (R&TC §25101.) This limitation is based on the
Commerce and Due Process Clauses of the US Constitution. (Mobil Oil
Corporation v. Commissioner of Taxes of Vermont (1980) 445 US 425;
ASARCO, Inc. v. Idaho State Tax Commission (1982) 458 US 307.)

The US government, however, has no such constitutional limitation.

In the international context, the only significant limitation on the US
taxing jurisdiction is self-imposed by Congress in the furtherance of
tax, foreign relations, and international trade policy considerations.
There are no provisions of international law or in the US Constitution
that in any way limit the worldwide jurisdiction to tax the income of US
citizens or residents, or income derived from property having some
connection with the US. In addition, the US can assert the right to tax
certain types of income of foreign corporations derived from foreign
sources, where such income is connected with the operation of a US
trade or business. (Internal Revenue Code (IRC) §864(c)(4)(B).)

The following table summarizes the US taxing jurisdiction over income

from sources inside and outside of the US.

US Tax Jurisdiction
Over Income From Sources
Entities In the US Outside the US

US Incorporated All All; Subject to

Foreign Tax Credit
Foreign Incorporated – ECI All; Subject to All; Subject to treaty
treaty
Foreign Incorporated – Non- Some; Subject to None
ECI treaty
Foreign Incorporated – ECI rules apply Subpart F income
Subsidiary of US Corporation taxed to shareholder

b. US Taxing Jurisdiction of US Corporations

Congress asserts the right to tax the income of entities incorporated in

the US. A US corporation is taxed on all its income, regardless of
source. (IRC §§11 and 61.)

c. US Taxing Jurisdiction of Foreign Corporations

Congress is more cautious with respect to entities incorporated in

foreign countries. It asserts jurisdiction to tax only income with some
connection with the US. In asserting source-based jurisdiction to tax
the income of foreign corporations, the US does not operate under a
“minimum connection” or “nexus” limitation, such as that applicable to
the states. Federal limitations are self-imposed, and they reflect a
broad range of international policy considerations.

A number of federal provisions apply to limit the taxing jurisdiction of

a foreign corporation’s income. Many of these topics are the subject of
separate chapters of this manual. Here is an outline of the treatment
of items based on distinctions between countries of incorporation,
types of income, and whether the income is related to US business
operations.

• In general, the US asserts jurisdiction to tax only the income of

a foreign corporation that is effectively connected with the
 conduct of a trade or business within the US as provided under
IRC §882. (IRC §11(b).) ECI is discussed in more detail in WEM
5.

• US jurisdiction to tax ECI is ceded to the country of incorporation

in certain instances. The most common method of doing so is by
means of tax treaties with foreign governments. (Tax treaties
are discussed in WEM 4.2 and WEM 5.)

• Source-based jurisdiction is not limited to ECI. Certain types of

income from US investments and activities, which do not rise to
the level of being a trade or business within the US, are subject
to tax under IRC §881. This is not the standard income tax
rates, but rather a special 30 percent tax rate that is generally
collected by means of withholding by the payor of the income.
(IRC §1442.) Tax treaties are, again, a significant factor when it
comes to this type of income; however, rather than operating to
cede jurisdiction to the country of residence of the payee, treaty
provisions generally reduce the applicable tax rate to something
less than the statutory 30 percent rate.

d. US Indirect Taxing Jurisdiction

The tax jurisdiction of the US extends to the earnings of foreign

incorporated entities, which are controlled by US shareholders. The
US imposes an income tax on US shareholders with respect to certain
types of income of their Controlled Foreign Corporations (CFC). This is
accomplished by means of a so-called “deemed dividend” pursuant to
the provisions of Subpart F of Part III of Subchapter N of the Internal
Revenue Code.
4.2 Tax Treaties

a. Nature of Tax Treaties

b. US Tax Treaties and California Law
c. Permanent Establishment (PE) and ECI
d. Tax Rate Reductions

a. Nature of Tax Treaties

The US government has entered into tax treaties or “tax conventions”

with numerous foreign countries. You can view the list of the tax
treaties at www.irs.gov. Treaties often operate to reduce tax rates
applied to certain types of income.

Tax treaties are generally entered into for the purpose of avoiding
international double taxation, which arises from competing claims of
governments to tax the same income. The US asserts taxing
jurisdiction on the worldwide income of US corporations, and also
source-based jurisdiction with respect to income earned here by
foreign corporations.

With respect to taxes imposed by the US, tax treaties are of primary
importance to foreign corporations from the standpoint of their
businesses and investments in the US. Benefits available to US
corporations under tax treaties generally are of a reciprocal nature.
The benefits are of the same nature as those provided to foreign-
resident companies by the US.

Based on constitutional procedures, US tax treaties are negotiated by

US Treasury Department representatives, and then signed by the
President. The treaty is then referred to the US Senate, who may
advise and consent to the treaty terms. (US Constitution, Art. II,
section 2, clause 2.) Ultimately, the treaty is ratified. Either treaty
country can unilaterally terminate the treaty.

The relationship of tax treaties and IRC provisions is rather

complicated. As a general rule, treaty provisions take precedence over
the statutory provisions. Note, the supremacy clause of the US
Constitution provides, “...all treaties made, or which shall be made,
under the authority of the United States, shall be the supreme law of
the land...” Also see IRC §894, which provides that the provisions of
the IRC shall be applied with due regard to any treaty obligation that
applies to the taxpayer. However, IRC §7852(d)(1) provides,
“...neither the treaty nor the law shall have preferential status by
reason of its being a treaty or law.” However, there are numerous
exceptions to the general rule in instances where statutes are passed
after treaties are ratified, and where Congress specifically provides
that the statute will take precedence over the treaty.

Treaties generally:
• Govern the tax treatment by one country of the residents or
citizens of the other.
• Set the requirements for nexus for taxation through the
permanent establishment (PE) rules.
• May provide for the reduction in tax rates applicable to
investment income.
• Promote mutual cooperation between governments in
furtherance of effective tax administration.
• Facilitate the resolution of disputes through the respective
governments’ “competent authorities.”
• Expedite exchanges of information between governments and
the carrying out of joint audit projects.

An important issue involving tax treaties has to do with the permanent

establishment (PE) rules. It may be important that a foreign corporate
resident of a treaty country confine its US activities in such a way that
it avoids having those activities meet the threshold requirements for a
US PE. If it does not have a PE, it pays no US tax. If it does have a
PE, it pays US tax on its net business income.

b. US Tax Treaties and California Law

The application of tax treaties under the water’s-edge statutes is

discussed in WEM 5. Tax treaties have important effects on water’s-
edge combined reports. For taxable years beginning before January 1,
1992, under the water’s-edge regulations, treaty provisions were
applicable to foreign banks and corporations operating in the US, to
the extent that they limited the definition of ECI for federal purposes.
(CCR §25110(d)(2)(F)2(a).)

For taxable years beginning on or after January 1, 1992, under

water’s-edge regulations, treaty provisions are not applicable to the
extent they limit the definition or taxation of ECI for federal purposes.
(CCR §25110(d)(2)(F)1(a).) Therefore, situations will occur where a
foreign bank or corporation is immune from federal tax because of tax
treaty provisions, but nonetheless has ECI under the IRC, which is
subject to inclusion in a water’s-edge combined report. In situations
where a taxpayer has tax treaty immunity, a state adjustment to the
water’s-edge return would be necessary to properly include the ECI.

Tax treaties between the US and foreign governments have only

limited application to California tax returns. Their application in a
water’s-edge context is strictly limited to their relation to the ECI
concept. The fact that a treaty grants to a foreign corporation an
exemption from US income tax does not mean that such entity is
exempt from the California franchise tax.

Example 1

Corporation A was formed under the laws of Country X. In 2013,

Corporation A is engaged in certain business operations in the state
of California, and is “doing business” in California within the
meaning of R&TC §23101. Country X has a tax treaty with the US.
Corporation A’s activity in California is such that, under the treaty,
Corporation A is effectively exempt from US income taxes.

For purposes of the water’s-edge combined report, Corporation A

would not recognize the treaty provisions to determine its water’s-
edge includible income and factors. Corporation A is subject to the
franchise tax, and must file a California tax return and include its
net ECI.

c. Permanent Establishment (PE) and ECI

The most important effects of treaties for US taxation purposes, as

well as for California water’s-edge purposes, are derived from the
concept of “permanent establishment” or “PE.” For federal purposes,
the first step in determining the US taxable income of a foreign
corporation is to determine whether that corporation is engaged in a
“trade or business” within the US. The second step is to determine the
ECI related to that trade or business in accordance with IRC §882.
Under a tax treaty, it does not matter whether the foreign corporation
has a trade or business in the US; rather, the important question is
whether the foreign corporation has a PE. These terms are discussed
in WEM 5.

d. Tax Rate Reductions

Another effect of US tax treaties can be the reduction in the tax rate
that applies to investment and certain other types of income not
related to a US trade or business.
4.3 Foreign Tax Credit

a. In General
b. Direct and Indirect FTCs
c. FTC Limitations

a. In General

For US multinationals, the FTC is of significant importance. It is

generally taken into consideration for determinations of the source of
income and deductions, intercompany pricing arrangements, Subpart F
considerations, and so on.

The principal goal of the FTC rules is the avoidance of international

double taxation that would otherwise result from the US asserting
residence-based jurisdiction, while a foreign government asserts
source-based jurisdiction over the same income. Refer to IRC §901
and the regulations thereunder.

A taxpayer can elect to deduct the foreign taxes, which it pays in

computing US taxable income, rather than claiming a credit for these
amounts. (IRC §901(a).) Foreign income taxes are generally
deductible under IRC §164(a)(3), but not if the credit is claimed per
IRC §275(a)(4). Since eligible foreign taxes are creditable in full to
reduce the US tax liability, the deduction route is preferable only in
rare circumstances. For example, if the taxpayer has no US tax
liability because it incurred current losses, and if the net operating loss
(NOL) carryover is greater than a carryover of the FTC, the deduction
would be preferable.

A foreign country may assert jurisdiction over income that is sourced

to the US under US rules, (i.e., there is a conflict of the source of
income definitions used by the US and the foreign country.) The US
would not allow a credit in this circumstance. Therefore, a taxpayer
would usually prefer a deduction worth something to no credit.

b. Direct and Indirect FTCs

Per IRC §§901(a) and (b) (1), the FTC is available with respect to
taxes paid directly by a US corporation that incurs the tax liability to
the foreign government. In this case, the taxpayer is said to claim a
“direct credit.” The FTC is also available with respect to taxes paid and
incurred by foreign subsidiaries of US corporations. In this case, the
taxpayer is said to claim a “deemed paid credit” or an “indirect” credit.
(IRC §§901(a) and 902.) Only by means of the special FTC rules can
the parent corporation obtain a US tax benefit from the foreign taxes
incurred by its subsidiary.

The direct FTC is fairly straightforward in application. The payor of the

foreign tax liability claims a credit for the amount paid against its US
tax liability, subject to the limitations discussed below. However, the
indirect credit is far more complicated in application. See Treas. Reg.
§§1.901 and 1.902 for complete rules and examples illustrating the
provisions of these two IRC sections.

c. FTC Limitations

IRC §904 provides for “categories” or “baskets” of the source of any

earned FTC. These baskets serve to limit the use of excess FTCs.
Excess FTC of one FTC basket can only be applied against a tax liability
of the same basket type. The number and types of baskets have
fluctuated over the years. Commencing on January 1, 2007, the
number of FTC categories was reduced from eight categories to two
categories. (IRC §904(d)(1).)

The two categories or baskets are:

1. General limitation income

2. Passive income
4.4 Source of Income and Deductions

a. In General
b. Source Rules for Income

a. In General

The federal source of income and deductions concept is different from

the California concept. The federal international taxation rules, e.g.,
the FTC, tax treaties, etc., frequently reference the “source” of
income. “Source” determinations are of great importance under the
US international tax rules.

The rules determining the source of income for US tax purposes serve
three major functions:

• First, the source of income determination is critical to the

calculation of IRC §904 limitations. This is of great concern to a
US corporation doing business abroad because it directly affects
the corporation’s ability to use FTCs to eliminate US income tax
on its foreign source income.

• Second, the source determination of income controls the

imposition of US income tax on a foreign corporation. The US
generally does not tax foreign corporations, except to the extent
that the foreign corporation earns:

• US source fixed and determinable, annual or periodic (FDAP)

income (IRC §§861and 881)

• Income effectively connected with the active conduct of a

trade or business in the US (ECI) (IRC §§864(c) and 882)

A foreign corporation or person is subject to US withholding tax

of 30 percent, subject to treaty reduction, on the gross amount
of US source FDAP income. (IRC §1442.) ECI generally is US
source income, but IRC §864 treats some types of foreign source
income as ECI. A foreign corporation is taxed on a net basis at
standard corporate rates on its ECI. (IRC §§882(a) and 882(c).)

• Finally, the source of income determination is important to the

computation of Subpart F income. Subpart F income does not
include US source income, unless the income is exempt from
taxation or is subject to a reduced tax rate. (IRC §§952 and
 952(b).) Therefore, whether income is US sourced or foreign
sourced income is a key factor in determining whether a CFC has
Subpart F income.

For a California water’s-edge tax return, the federal source of income

and deduction rules is important in the determination of apportionable
income of certain foreign-nation banks and corporations with branches
in the US (US source income). There are two other water’s-edge areas
where the federal sourcing rules have indirect application:

1. The water’s-edge regulations governing the “interest offset”

under R&TC §24344(c) is based in large part on the federal rules
governing the determination of the source of interest deductions.
(CCR §24344(c) and Treas. Reg. §1.861-9.)

2. The intercompany allocation rules for services in both the

water’s-edge and non-water’s-edge context. Treas. Reg.
§1.861-8(e)(4) includes a discussion of so-called “stewardship
expenses,” and the means for determining their source with
respect to certain dividends. The source determination
regulation includes a cross-reference to the allocation regulation,
Treas. Reg. §1.482-9, performance of services for another. It
explains more clearly the stewardship expenses concept, which
is introduced in the allocation regulation. This source regulation
is of limited importance to water’s-edge tax returns. However,
you may wish to refer to the regulation as an aid to
understanding the rules relating to allocations for services under
IRC §482.

Under the water’s-edge regulations, the determination of the income

and factors of foreign national banks, and corporations with branches
in the US, who are included in a water’s-edge combined report, must
be made according to the federal rules for determining the income
attributable to US sources, either from a US trade or business (ECI) or
from US investments. (CCR §25110(d)(2)(F).)

Application of these rules is discussed in WEM 5.

b. Source Rules for Income

The term "source" is a geographic concept that assigns income to a

particular situs. The federal sourcing rules first look to the type of
income involved, and then applies a specific set of rules to that type of
income. Sourcing of income is discussed in WEM 5.

Do not confuse the federal sourcing rules with the California market
based sourcing rules.
4.5 Transfer Pricing

IRC §482 grants the IRS the authority to allocate income and
deductions among related organizations. The IRS may do this
whenever an allocation is “necessary in order to prevent evasion of
taxes or clearly to reflect...income.” For example, if a US corporation
causes income, which it has earned by means of its property or
activity, to be received by its foreign subsidiary, and thus shields such
income from US taxation, IRC §482 empowers the IRS to reallocate
such income to the US corporation. California conforms to IRC §482.
(R&TC §25725.) See WEM 15, Intercompany Transfer Pricing.
4.6 Tax Havens and Subpart F

A “tax haven” is considered to be any jurisdiction that taxes income at

a lower effective rate than do competing jurisdictions.
Discussions of tax havens can be found in many international tax
areas. For example, tax haven issues were addressed in E.I. Du Pont
de Nemours and Co. v. US (1979) 608 F.2d 445. In 1959, Du Pont
created a wholly owned subsidiary, known as DISA in Switzerland.
DISA’s function was a marketing and sales arm of Du Pont. DISA
purchased large volumes of chemical products manufactured by Du
Pont in the US. These products were intended for resale as raw
materials to manufacturers and as finished, or semi-finished, goods.
DISA resold the products to manufacturers throughout Europe, as well
as in Australia and South Africa.

Although title to these large volumes of bulk chemicals transferred

from Du Pont to DISA and then to the ultimate customers, the goods
flowed from DU Pont to the ultimate customers. Switzerland was
selected as the venue for Du Pont’s sales subsidiary because of Swiss
tax incentives; that is, because DISA would be subject to little or no
income tax on its earnings from sales to customers outside
Switzerland. An important feature of the arrangement between Du
Pont and DISA was the setting of “a selling price sufficiently low as to
result in the transfer of a substantial part of the profits on export sales
to the “PST” company, according to a Du Pont internal memorandum.
“PST” was Du Pont shorthand for “profit sanctuary trading company.”
The IRS adjusted Du Pont’s tax returns under IRC §482 for the
undercharging of DISA. The US Court of Claims sustained the IRS
adjustments.

Du Pont’s use of DISA in Switzerland can be viewed as a classic

illustration of the use of a tax haven. Switzerland was used as the
base of operations of the sales company to put profits into that
company to reduce the company’s overall tax burden.

The idea that profits could be placed in a tax haven was objectionable
from a tax policy standpoint. IRC §482 addresses only one aspect of
such problems, and is a rather cumbersome tool to use. In 1962
Congress enacted the “Subpart F” rules of the IRC to deal with the tax
haven problem. (Public Law 87-834, §12(a).) “Subpart F” refers to
the placement of these provisions within Part III of Subchapter N of
Chapter 1 of the IRC.
The Subpart F provisions apply to foreign business and investment
operations controlled by US taxpayers. The underlying principle is that
income should be taxed where it is earned, and that if income accrues
in the hands of an entity operating in a tax haven, then such income
should be taxed to the person controlling the events. This is
accomplished by means of what is often referred to as a “deemed
dividend.” Under IRC §951, a controlling US shareholder is currently
taxed on tax haven earnings that meet the definition of Subpart F
income, without regard to whether the subsidiary pays a current
dividend.

Subpart F is discussed in WEM 2.

4.7 US Possessions Corporations

Subpart D of Subchapter N of Chapter 1 of the IRC contains specific

rules under which electing US corporations operating in US
possessions, e.g., Puerto Rico or the US Virgin Islands, in essence pay
no federal income tax on qualifying income earned within the
possession. An electing possessions corporation must file a separate
federal Form 1120. It cannot file a consolidated federal tax return.

A “possessions” corporation is generally taxed on its worldwide income

in a manner similar to any other US corporation. However, IRC §936
provided a special tax credit for US corporations operating in Puerto
Rico, the US Virgin Islands or other US possessions, if the possessions
corporation was an existing credit claimant. (An existing credit
claimant is a corporation that had made an IRC §936 election, was
actually conducting operations in a US possession on October 13,
1995, and was claiming the credit during that taxable year.)

In 1996, amendments were made to IRC §936 to phase-out the credit

over a ten-year period. The IRC §936 credit ends with the last taxable
year beginning before January 1, 2006.

For taxable years beginning on or after January 1, 2006, a US

possessions corporation are treated like any other US incorporated
entity.
4.8 Out-Bound Transfers

The US government taxes US incorporated entities on all of their

income and foreign incorporated entities on their US income.
Governance of transactions and investments across international lines
is manifested in the application of the arm’s length principle embodied
in IRC §482, and the Subpart F provisions.

Subchapter C of Chapter 1 of the IRC allows for the tax-free (or tax-
deferred) exchange of appreciated property in a number of contexts,
e.g., IRC §§332, 351, 354, 355 and 361. However, in some instances
the Subchapter C deferral rules may result in a permanent loss to the
US Treasury.

IRC §351 is not restricted in any sense to application only to US

corporations. Compare IRC §351(a) and the definition of “corporation”
at IRC §7701(a)(3). The potential of escaping taxation from a transfer
of property from the US to a foreign corporation is mitigated by the
provisions of IRC §367. The general rule of IRC §367(a) is that gain is
recognized on a transfer of property to a foreign corporation,
notwithstanding the deferral provisions of Subchapter C. This is
accomplished by providing that a “foreign corporation shall not ... be
considered to be a corporation” for purposes of the application of the
Subchapter C provisions. For example, IRC §351(a) provides for no
gain or loss if property is “transferred to a corporation.” The most
important exception to this rule is for property that will be used in the
active conduct by the foreign corporation of a trade or business in a
foreign country in accordance with IRC §367(a)(3). Exceptions to this
exception, requiring gain recognition on transfer, apply to certain
types of property that are likely to be resold promptly or are highly
fungible, such as inventory, receivables, foreign currency or foreign
currency denominated investments, and interests in leased property.
(IRC §367(a)(3)(B).)

Gain is also required to be recognized on certain transfers of intangible

personal property, such as patents or know-how, even though used in
an active trade or business, based on the theory that the same or a
similar business purpose could be achieved by means of a license,
where the property remains in the hands of the US developer of the
intangible. A further theory could be that it is inappropriate to allow
the tax-free exploitation of intangibles developed by means of costs
and expenses incurred in the development process in the US. (IRC
§367(a)(3)(b)(iv).) This rule is augmented by the provisions of IRC
§367(d), which requires, in the cases of IRC §351 or §361 transfers,
that a transfer of an intangible be deemed to be a licensing
arrangement, giving rise to a periodic royalty from the controlled
foreign subsidiary to the US developer of the intangible asset.

IRC §367(b) similarly provides for exceptions to the Subchapter C

provisions where property is transferred from one foreign corporation
to another. IRC §367 provisions apply to California water’s-edge tax
returns. Indeed, they apply to all California franchise tax returns.
(See R&TC §24451.) Thus, a transfer of property from a water’s-edge
taxpayer, or its affiliate in a water’s-edge combination, to a foreign
affiliate can give rise to apportionable gain in the water’s-edge
combined report.

For further discussion of out-bound transfers, IRC §367, see WEM 16.
4.9 Export Sales Incentives

For many years, the US provided US corporations tax incentives to

promote export of goods from the US. For most of the last three
decades, these benefits were provided under three regimes that
provided export-related benefits. The three tax regimes are:

1. Domestic International Sales Corporations (DISC) – DISC

provisions were enacted in the Revenue Act of 1971 as IRC
§§991 to 994. To qualify as a DISC, at least 95 percent of its
gross receipts must be "qualified export receipts" as defined in
IRC §993(a). For federal purposes, DISCs rules continue to
have limited application. DISCs are subject to favorable transfer
pricing rules and partial deferral of income on foreign sales.

2. Foreign Sales Corporations (FSC) – FSC provisions were

enacted in 1984 as IRC §§921 to 927, and §291(a)(4). The FSC
rules largely replaced the DISC rules. Generally, FSCs are
foreign subsidiaries of US companies that export goods. The
FSC sells products supplied by its US parent. If a corporation
qualifies for and elects FSC status, a portion of the FSC income
is attributable to the US parent, and the other portion is exempt
from US taxation.

3. Extraterritorial Income (ETI) – The ETI was enacted by the FSC

Repeal and Extraterritorial Income Exclusion Act of 2000. The
ETI did not provide for a new entity like a DISC or a FSC.
Instead, it excluded all foreign trade income from a US
exporter's gross income. (IRC §114.)

California does not conform to any of the above three tax regimes
related to export trade. For California purposes, DISCs and FSCs are
treated as regular corporations and are fully included in the combined
report whether the group files under worldwide or water's-edge. (For
additional information see MATM section 5220.) Regarding ETI,
taxpayers are required to add back as a state adjustment any federal
income exclusion related to ETI.
4.10 US Branches of Foreign Corporations

A corporation, a single legal entity, may of course conduct its business

activities in more than one country. When a corporation is based in
one country, but establishes a place of business in another, the other
place of business is often referred to as a “branch” or “branch
operation.” (IRC §884.) Such branch operations have legal
significance under the US tax laws.

US international tax policy has been concerned with equalizing the tax
treatment of operations conducted through subsidiaries and through
branches. For example, if a foreign-based multinational seeks to
establish a business presence in the US, it should make no difference
in terms of its income tax burden if it does so through the formation of
a US subsidiary corporation or through the establishment of a branch
operation. This concept is expressed through numerous provisions of
the IRC dealing with the taxation of foreign investors and foreign
businesses in the US. For example, the tax burden of an entity
operating through a PE in the US under most tax treaties will
approximate the tax burden of a separately incorporated US subsidiary
operating in the same manner.

The general concept of attempting to equalize the taxation of branch

and subsidiary operations has occurred much less consistently in the
“outbound” context where a US-based corporation operates through a
branch or subsidiary in a foreign country. However, traces of such a
policy objective can be found in the IRC provision dealing with sources
of income with respect to the FTC, in Subpart F, in the treatment of
contiguous country subsidiaries under IRC §1505 (d), and elsewhere.

It is important to recognize the separate status of branch operations in

the context of California water’s-edge. Under the California water’s-
edge system, it is indeed significant whether operations are conducted
through branches, in either the inbound or the outbound context.
Moreover, under water’s-edge there are important differences between
the treatment of branches of foreign banks and those of foreign
corporations, which are not banks.

Branches and deemed subsidiaries are discussed in WEM 5.

4.11 US Dollars and Other Currencies

Though the US dollar is the currency of the US, obviously not all
payments for goods and services and investments are made in that
form. The IRC includes special provisions governing the handling of
transactions denominated in foreign currencies. IRC §§985 to 989
include the key foreign currency provisions applicable to multinational
business operations. Among issues addressed by these provisions,
these are of concern in the water’s-edge combined report context:

1. Determination of net taxable income in dollars of a foreign

branch operation of a US corporation, which uses a foreign
currency designation for its books and records.

2. Determination of net taxable income in dollars of a US branch of

a foreign corporation, which uses a foreign currency designation
for its books and records.

3. Computation of E&P in dollars of a foreign subsidiary with

Subpart F income, which has made a distribution.

The IRC §§985 to 989 rules and their application are discussed in WEM
8.