US International tax_ Asset/Tooling/Outside of the US

 Q- What is tax implication where the US entity owns asset outside of the US?

A- US tax implications when a US entity (like a corporation, partnership, LLC, etc.) owns assets outside the United States.

Key implications:
1. Worldwide Taxation: The fundamental principle is that the US taxes its residents, including US entities, on their worldwide income. This means income generated by assets located outside the US is generally subject to US taxation, regardless of whether the income or the asset is brought back into the US.

2.Income Recognition:
(1) Operating Income: Income generated directly from the foreign asset (e.g., rental income from foreign real estate, royalties from foreign licenses, sales income from inventory held abroad) is typically included in the US entity's taxable income when earned or received, depending on the entity's accounting method.
(2) Gains from Sale: When the foreign asset is sold, any gain (sale price minus adjusted basis) is generally subject to US tax. The character of the gain (capital vs. ordinary) depends on the nature of the asset and how it was used.
(3) Dividends/Interest: If the "asset" is stock in a foreign company or a loan to a foreign entity, dividends and interest received are generally US taxable income.

3. Foreign Tax Credits (FTCs) or Deductions:
To mitigate double taxation (being taxed by both the foreign country and the US on the same income), the US entity can generally choose to either:

A. Claim a Foreign Tax Credit (FTC): This directly reduces the US tax liability on foreign source income, subject to limitations (e.g., you can't credit more foreign tax than the US tax attributable to that foreign income). This is often the more beneficial option. (See Forms 1118 for corporations, 1116 for individuals/pass-throughs).  

B. Claim a Deduction: Alternatively, the entity can deduct the foreign income taxes paid. This reduces taxable income rather than the tax liability itself.

4. Reporting and Disclosure Requirements: This is crucial. The IRS requires extensive reporting for foreign assets and activities to ensure compliance. Failure to file these forms can result in significant penalties, even if no tax is owed. Key forms include:  

A. Form 5471: Information Return of U.S. Persons With Respect to Certain Foreign Corporations (if the asset is stock in a foreign corporation meeting certain ownership thresholds).

B. Form 8865: Return of U.S. Persons With Respect to Certain Foreign Partnerships (if the asset is an interest in a foreign partnership).  

C. Form 8938: Statement of Specified Foreign Financial Assets (required if the total value of such assets exceeds certain thresholds). This includes assets like foreign bank/brokerage accounts, stock/securities not held in an account, foreign partnership interests, etc.  

D. FinCEN Form 114 (FBAR): Report of Foreign Bank and Financial Accounts (filed with the Treasury Department's Financial Crimes Enforcement Network, not the IRS). Required if the aggregate value of foreign financial accounts exceeds $10,000 at any time during the year.  

E. Form 8858: Information Return of U.S. Persons With Respect To Foreign Disregarded Entities (FDEs) and Foreign Branches (FBs).  

F. Form 926: Return by a U.S. Transferor of Property to a Foreign Corporation.    

 

5. Impact of Holding Structure: How the asset is held matters significantly:

A. Direct Ownership: Income/loss flows directly to the US entity.

B. Foreign Branch: Treated similarly to direct ownership; income/loss is consolidated with the US entity's results.

C. Foreign Corporation (Subsidiary): This creates complexity. US tax might be deferred until earnings are repatriated as dividends. However, anti-deferral regimes like Subpart F and GILTI (Global Intangible Low-Taxed Income) can cause certain types of foreign corporate income to be taxed currently in the US, even if not distributed.  

D. Foreign Partnership: Generally treated as pass-through for US tax purposes, but reporting (Form 8865) is complex.  

6. Specific Tax Regimes: Depending on the structure (especially if held via foreign corporations), complex regimes may apply:

A. Subpart F Income: Targets passive income (like interest, dividends, royalties) and certain related-party sales/services income earned by Controlled Foreign Corporations (CFCs), taxing it to US shareholders currently.

B. GILTI (Global Intangible Low-Taxed Income): A broad regime that effectively imposes a minimum tax on most active business income of CFCs that isn't otherwise taxed under Subpart F or other exceptions, taxing it currently to US shareholders.

C. FDII (Foreign-Derived Intangible Income): Provides a deduction (lower tax rate) for certain income derived by US corporations from foreign use of intangible property held in the US.  

D. BEAT (Base Erosion and Anti-Abuse Tax): An additional minimum tax primarily impacting larger corporations making certain deductible payments to related foreign parties.

7. Foreign Currency Transactions: Gains or losses can arise from fluctuations in currency exchange rates when dealing with foreign assets or income streams denominated in a foreign currency (governed by IRC Section 988).  

In Summary:

Owning foreign assets as a US entity triggers US taxation on the income generated by those assets and mandates extensive reporting. While mechanisms like the Foreign Tax Credit exist to prevent double taxation, the rules (especially involving foreign corporations and anti-deferral regimes like Subpart F and GILTI) are highly complex and depend heavily on the specific facts, asset type, and holding structure.  

https://www.thetaxadviser.com/issues/2024/aug/foreign-partnership-reporting-requirements/

https://www.russellbedford.us/news/unveiling-the-hidden-costs-how-non-compliance-in-foreign-asset-reporting-could-lead-to-substantial-penalties/#:~:text=

https://thewolfgroup.com/who-we-serve/residents-with-global-assets/

https://www.taxesforexpats.com/articles/tax-saving-strategies/foreign-tax-credit.html

https://www.taxnotes.com/procedurally-taxing/problems-facing-taxpayers-foreign-information-return-penalties-and-recommendations-improving-system/2020/01/06/7h76l

Q- In this case, for example, if the US entity owns the tooling in Mexico, to mitigate those issues, if Mexico affiliated entity owns it and send the intercompany invoice to the US entity for the asset depreciation. Is this correct treatment?

A- That's a common strategy companies consider, but invoicing specifically for depreciation is generally not the correct treatment for an intercompany charge related to the use of an asset. Here's a breakdown of why and what the implications are:

1. Depreciation vs. Intercompany Charge:

• Depreciation: Is an accounting and tax concept for the owner of the asset. It represents the allocation of the asset's cost over its useful life. It's an internal expense calculation for the entity that owns the asset (in your proposed scenario, the Mexican entity).  
• Intercompany Charge: When one related entity provides something of value to another (like the use of tooling), the charge should reflect an arm's-length price for the benefit provided. This isn't typically a direct pass-through of the owner's depreciation expense.  

2. Correct Intercompany Charge Mechanism:
If the US entity is essentially using the tooling owned by the Mexican entity, the appropriate charge would likely be structured as:

• A rental or lease payment: The US entity pays the Mexican entity a fee for the right to use the tooling. This fee should be comparable to what unrelated parties would charge for leasing similar equipment under similar conditions.
• A service fee: If the Mexican entity is using the tooling to perform a service (e.g., manufacturing parts) for the US entity, the fee would cover the cost of that service, which would implicitly include costs associated with the tooling (like depreciation, maintenance), labor, overhead, plus an appropriate profit markup.

3. Tax Implications of the Proposed Structure (Mexico Affiliate Owns):

• Mexican Entity:
• Owns the tooling and claims depreciation deductions on its Mexican tax return.
• Receives rental/lease/service income from the US entity, which is subject to Mexican income tax.  
• Must comply with Mexican transfer pricing rules, ensuring the charge to the US is arm's length.
• Potential Mexican VAT implications.
• US Entity:
• Does not own the asset directly, avoiding the direct US tax reporting associated with owning that specific foreign asset (though reporting related to the affiliated entity itself like Form 5471/5472 likely still applies).
• Pays the intercompany rental/lease/service fee to the Mexican entity.
• This payment is generally a deductible business expense for US tax purposes, provided it meets the arm's-length standard under IRC Section 482 (Transfer Pricing).
• Transfer Pricing Risk: This is the major compliance area. Both the IRS and Mexican tax authorities will require the intercompany charge to be justifiable as arm's length. This often requires a formal transfer pricing analysis and documentation. If the price is deemed incorrect, authorities can adjust taxable income, leading to double taxation, interest, and penalties.
• US Withholding Tax: Payments for rent/lease made from the US to Mexico could potentially be subject to US withholding tax, although the US-Mexico tax treaty often reduces or eliminates this.
• BEAT (Base Erosion and Anti-Abuse Tax): If the US entity is large enough, payments to related foreign parties can potentially trigger BEAT implications.

Does it Mitigate Issues?

• It shifts the direct ownership and associated depreciation from the US entity to the Mexican entity.
• It replaces the complexities of direct foreign asset ownership/depreciation by the US entity with the complexities of intercompany transactions and transfer pricing compliance.
• It does not eliminate the economic cost associated with the tooling from impacting the US entity's overall tax position; it just changes the character from potential foreign income/direct asset considerations to a deductible expense (the intercompany charge).

Conclusion:

While having the local affiliated entity own the asset is a valid structuring option, invoicing specifically for depreciation is incorrect. The proper method involves an arm's-length charge (like rent/lease/service fee). This structure requires robust transfer pricing analysis and documentation to be sustained under scrutiny by both US and Mexican tax authorities. It trades one set of tax compliance issues for another, rather than simply eliminating them.

https://policies.iu.edu/policies/fin-acc-180-depreciation-capital-assets/archived-09042018.html