Multiple Jurisdictions

With “Basic Tax Rate Concepts” as background, this lesson covers decisions where more than one jurisdiction imposes income tax. To determine the overall MTR, build a simple model or equation that appropriately combines MTRs from the separate jurisdictions. This lesson focuses on income subject to: (1) U.S. and state income tax and (2) U.S. and foreign income tax.

U.S. and State Income Tax

For a given decision, combining U.S. and state MTRs to obtain an overall MTR involves more than summation. In the United States, §164 allows taxpayers to deduct state and local income taxes in computing federal income tax. In contrast, states do not allow deductions for U.S. income taxes. The federal deduction means the MTR can be expressed as follows:

 (1)

In a departure from the way equations appeared in the first two lessons, Equation 1 emphasizes rates rather than dollar amounts. To clarify, the “state marginal tax rate” is the MTR applicable in the absence of the federal income tax. Similarly, the “U.S. marginal tax rate” is the MTR applicable before considering the state income tax. Thus, the basic definitional formula is appropriate for separately determining the state and U.S. marginal tax rates in Equation 1. As a reminder, the basic MTR formula is:

 (2)
 Example 1: Adelphi Corporation, a U.S. entity, expects taxable income of \$16 million this year. All its business activities take place within a single state that imposes a 6% income tax; Adelphi does not establish nexus in any other state and does not conduct offshore activities. The opportunity to earn an additional \$1 million of profit is subject to a MTR calculated as follows: MTR = .06 + .38 (1 - .06) = 41.7% The 38% rate is the statutory corporate rate attributable to taxable income between \$15 million and \$18.3 million (see the corporate tax rate schedule in the “Basic Tax Rate Concepts” lesson) and, thus, represents the “U.S. marginal tax rate” attributable to the \$1 million incremental income.

U.S. and Foreign Income Tax

Increasingly, U.S. companies engage in some international commerce. When U.S. companies conduct business abroad via permanent establishments or PEs (e.g., branches, selling divisions, or retail outlets), they frequently pay foreign income tax on any related profit. In addition, the United States taxes the worldwide income of its citizens, residents, and corporations. Thus, foreign countries and the United States often claim jurisdiction to tax the same profit, the former if the income is attributable to PEs within their boundaries and the latter based on U.S. citizenship, residency, or incorporation.

To mitigate the effect of the same profit being taxed by two countries, §901 permits a foreign tax credit (FTC) to U.S. persons paying foreign income tax. When the foreign tax rate exceeds the U.S. rate, §904 limits the FTC. Without getting into the legal technicalities, one can summarize the economic impact of these Code sections as follows:

 (1) When conducting business abroad in a low-tax jurisdiction via a foreign PE, a U.S. company pays tax to the foreign country at the latter’s statutory rate. The United States taxes the profit only at the difference between the U.S. and foreign rates, which some call the U.S. residual tax. (2) When conducting business abroad in a high-tax jurisdiction via a foreign PE, a U.S. company pays tax to the foreign country at the latter's statutory rate. The FTC eliminates any U.S. tax otherwise due.

The following equation captures the essence of these two points:

 (3)

As before, use the basic definitional formula in Equation 2 to compute the two separate rates appearing in Equation 3. Also, to keep things simple, Equation 3 assumes that the foreign jurisdiction does not withhold tax on profits remitted to the United States (i.e., a branch profits tax).

To determine the “foreign marginal tax rate,” consider not only a foreign country’s income tax but also surtaxes and local income taxes. If based on income, all these payments usually qualify for the FTC.

 Example 2: Beechwood Corporation's annual taxable income from within the United States exceeds \$20 million, placing the company in the 35% tax bracket. Beechwood contemplates opening a sales branch in Hungary. If established, the branch should add \$2 million profit from sales to Hungarian businesses. Assume the Hungarian marginal tax rate is 18% and Hungary does not tax profit remittances between a Hungarian branch and a U.S. corporation. Equation 3 yields the following MTR: MTR = MAX [.18 + (.35 - .18), .18] = 35% In effect, Beechwood pays an 18% tax to Hungary and then a 17% residual tax to the United States. Stated differently, the United States taxes the \$2 million at 35% but allows a FTC equal to 18% resulting in a net 17% tax on foreign profit.

 Example 3: Each year, Collard, Inc. earns \$5 million taxable income but has the chance to double this profit if it establishes a Belgian sales branch to exploit a new consumer market. Assume Belgium taxes profit at 40.2% but also imposes a 3% “crisis tax” on its regular tax. The combined foreign tax rate in Belgium equals 41.4% or 40.2% x 1.03. The MTR is determined as follows: MTR = MAX [.414 + (.34 - .414), .414] = 41.4% Collard pays tax to Belgium on its branch profits at 41.4%, but the FTC eliminates any U.S. tax otherwise due. In effect, Collard pays income tax at the higher of the U.S. or Belgian rate.

The legal rules appearing in §901, §904, and related provisions are much more complex than the earlier itemized points suggest. Nonetheless, these simple generalizations provide reasonable estimates of MTRs in many situations.

This lesson explains how to calculate MTRs when multiple jurisdictions impose tax on a person receiving all income and paying all tax in the current year. The next lesson explains how to combine MTRs of related persons into anoverall MTR. However, before proceeding to the “Multiple Persons” lesson, please take the self-tests covering multiple jurisdictions to assure your understanding. Also, please complete the “Short Exit Questionnaire” before leaving the site.