Question

4. Todor owns a U.S. corporation that operates a subsidiary corporation in Bulgaria. Because of the world wide tax approach adopted in the United States, all income of the Bulgarian subsidiary is potentially taxed twice, once in Bulgaria and again in the United States. Name and provide a brief description of the adjustments available on the U.S. return of the parent corporation which mitigate the impact of this potential double tax on all Bulgarian income?

Answer 1

ARTICLE 22 (RELIEF FROM DOUBLE TAXATION) This Article describes the manner in which each Contracting State undertakes to relieve double taxation. The United States uses the foreign tax credit method under its internal law, and by treaty. Paragraph 1 Paragraph 1 provides that Bulgaria will provide relief from double taxation through a mixture of the credit and exemption methods. Subparagraph 1(a) states the general rule that Bulgaria will exempt income derived by a resident if the income may be taxed in the United States in accordance with the Convention. Subparagraph 1(c), permits Bulgaria to include the income corresponding to the U.S. tax in the resident’s tax base in calculating the Bulgarian tax on the remaining income of the resident. This rule provides for “exemption with progression.” Under subparagraph 1(b), Bulgaria provides for a tax credit rather than an exemption with respect to limited classes of income. If the income may be taxed by the United States under the provisions of Article 10 (Dividends), Article 11 (Interest), or Article 12 (Royalties), Bulgaria will relieve double taxation by allowing a credit against Bulgarian tax in an amount equal to the tax paid in the United States on such income, but limited to the amount of Bulgarian tax attributable to such dividends, interest, and royalty income. Paragraph 2 The United States agrees, in paragraph 2, to allow to its citizens and residents a credit against U.S. tax for income taxes paid or accrued to Bulgaria. Paragraph 2 also provides that Bulgaria’s covered taxes are income taxes for U.S. purposes. This provision is based on the Treasury Department’s review of Bulgaria’s laws. Subparagraph (b) provides for a deemed-paid credit, consistent with section 902 of the Code, to a U.S. corporation in respect of dividends received from a corporation resident in Bulgaria of which the U.S. corporation owns at least 10 percent of the voting stock. This credit is for the tax paid by the corporation to Bulgaria on the profits out of which the dividends are considered paid. The credits allowed under paragraph 2 are allowed in accordance with the provisions and subject to the limitations of U.S. law, as that law may be amended over time, so long as the general principle of the Article, that is, the allowance of a credit, is retained. Thus, although the Convention provides for a foreign tax credit, the terms of the credit are determined by the provisions, at the time a credit is given, of the U.S. statutory credit. 67 Therefore, the U.S. credit under the Convention is subject to the various limitations of U.S. law (see, e.g., Code sections 901-908). For example, the credit against U.S. tax generally is limited to the amount of U.S. tax due with respect to net foreign source income within the relevant foreign tax credit limitation category (see Code section 904(a) and (d)), and the dollar amount of the credit is determined in accordance with U.S. currency translation rules (see, e.g., Code section 986). Similarly, U.S. law applies to determine carryover periods for excess credits and other inter-year adjustments. Paragraph 3 Paragraph 3 provides a re-sourcing rule for gross income covered by paragraph 2. Paragraph 3 is intended to ensure that a U.S. resident can obtain an appropriate amount of U.S. foreign tax credit for income taxes paid to Bulgaria when the Convention assigns to Bulgaria primary taxing rights over an item of gross income. Accordingly, if the Convention allows Bulgaria to tax an item of gross income (as defined under U.S. law) derived by a resident of the United States, the United States will treat that item of gross income as gross income from sources within Bulgaria for U.S. foreign tax credit purposes. In the case of a U.S.-owned foreign corporation, however, section 904(h)(10) may apply for purposes of determining the U.S. foreign tax credit with respect to income subject to this re-sourcing rule. Section 904(h)(10) generally applies the foreign tax credit limitation separately to re-sourced income. Furthermore, the paragraph 3 re-sourcing rule applies to gross income, not net income. Accordingly, U.S. expense allocation and apportionment rules, see, e.g., Treas. Reg. section 1.861-9, continue to apply to income resourced under paragraph 3. Paragraph 4 Paragraph 4 provides special rules for the tax treatment in both States of certain types of income derived from U.S. sources by U.S. citizens who are residents of Bulgaria. Since U.S. citizens, regardless of residence, are subject to United States tax at ordinary progressive rates on their worldwide income, the U.S. tax on the U.S. source income of a U.S. citizen resident in Bulgaria may exceed the U.S. tax that may be imposed under the Convention on an item of U.S. source income derived by a resident of Bulgaria who is not a U.S. citizen. The provisions of paragraph 4 ensure that Bulgaria does not bear the cost of U.S. taxation of its citizens who are residents of Bulgaria. Subparagraph (a) provides, with respect to items of income from sources within the United States, special credit rules for Bulgaria. These rules apply to items of U.S.-source income that would be either exempt from U.S. tax or subject to reduced rates of U.S. tax under the provisions of the Convention if they had been received by a resident of Bulgaria who is not a U.S. citizen. The tax credit allowed by Bulgaria under paragraph 4 with respect to such items need not exceed the U.S. tax that may be imposed under the Convention, other than tax imposed solely by reason of the U.S. citizenship of the taxpayer under the provisions of the saving clause of paragraph 4 of Article 1 (General Scope). For example, if a U.S. citizen resident in Bulgaria receives portfolio dividends from sources within the United States, the foreign tax credit granted by Bulgaria would be limited to 10 percent of the dividend – the U.S. tax that may be imposed under subparagraph 2(b) of Article 10 (Dividends) – even if the shareholder is subject to U.S. net income tax because of his U.S. citizenship. Subparagraph 4(b) eliminates the potential for double taxation that can arise because subparagraph 4(a) provides that Bulgaria need not provide full relief for the U.S. tax imposed on its citizens resident in Bulgaria. The subparagraph provides that the United States will credit the 68 income tax paid or accrued to Bulgaria, after the application of subparagraph 4(a). It further provides that in allowing the credit, the United States will not reduce its tax below the amount that is taken into account in Bulgaria in applying subparagraph 4(a). Since the income described in paragraph 4(a) generally will be U.S. source income, special rules are required to re-source some of the income to Bulgaria in order for the United States to be able to credit the tax paid to Bulgaria. This re-sourcing is provided for in subparagraph 4(c), which deems the items of income referred to in subparagraph 4(a) to be from foreign sources to the extent necessary to avoid double taxation under subparagraph 4(b). Subparagraph 3(e) of Article 24 (Mutual Agreement Procedure) provides a mechanism by which the competent authorities can resolve any disputes regarding whether income is from sources within the United States.