United States: Basic Principles of International Taxation

This paper will review the tax aspects of U.S. persons with foreign contacts and, as a reference to that, foreign persons with U.S. contacts. Although the discussion relates to the tax laws of the United States, that is frequently only half of the required discussion. Applicable foreign tax laws must be considered in any international transaction. Hence, the most that can be done here is to alert the reader to the problems, touch on the known U.S. tax issues presented and call attention to the flip side of the coin, some of the local law issues which must also be addressed. In this regard the Appendix to this paper is a glossary of the most often used terms in the lexicon of international tax.

Every U.S. person, including a U.S. citizen or U.S. tax resident (which includes aliens either resident or physically present for an extended period of 183 days (IRC §7701(b)) is required to file a U.S. income tax return covering all of his or her worldwide income. IRC §6012. The U.S. is almost unique in this regard. Almost all of the industrialized countries tax citizens and aliens on the basis of residency and not citizenship. Hence, a British subject not ordinarily resident in the United Kingdom is no longer subject to UK taxes except with respect to UK-source income, rents, alimony, pensions, etc. However, U.S. citizens and resident aliens do get a bit of a break on their U.S. income tax liability while they are working or residing abroad. Technically not ex-pats or expatriates (i.e., persons who have voluntarily given up their U.S. citizenship and are subject to IRC §§ 877 and 2107), but frequently referred to as such, U.S. citizens who are abroad for either 330 days out of 12 months, or reside abroad for a full calendar year or more, can exclude up to $76,000 of earned income each year. IRC §911.

Corporations and partnerships formed under U.S. laws are also considered U.S. persons in a tax sense. IRC §7701(a) (4). This is also in keeping with the separate juridical and fiscal personality recognized as being attached to such persons by our laws and regulations. Understanding this basic fact will go a long way in helping you to understand the maze of laws and restrictions which have grown up around the activities of such legal persons.

While not precisely relevant to the issues confronting the entry of a U.S. person into a new market, the method by which the United States taxes persons not subject to its personal jurisdiction is instructive as it will serve to illustrate the extent as well as the limits of a nation state to tax the income of persons normally considered to be beyond the scope of its fiscal laws. Most countries follow the same general pattern as that followed in our own country. Income is typically divided between income derived from passive sources and from the active conduct of a trade or business.

A. Passive income (see, IRC §§871-879) is taxed at a brut (not a net) 30 percent withholding tax rate and imposed on nonresident aliens (NRA) and foreign corporations that derive Fixed or Determinable Annual or Periodic U.S. Source Income (commonly referred to as FDAP income). IRC §§1441-1442 FDAP income includes interest, dividends, rents, royalties and the like, although interest in certain cases is tax free, specifically Portfolio Interest (IRC §871(h)) and interest on bank deposits. The rate of tax is often modified by Treaty (see, discussion in Section VII, below). However, capital gains realized by a foreign person from the disposition of intangible property are generally not subject to U.S. tax (e.g., resulting from a foreign person’s sale of stock in a U.S. Company), unless they constitute business income (but, see, discussion of Real Property in Paragraph D below).

B. Business Income (IRC §864) The income of an NRA effectively connected with the active conduct of a trade or business in the U.S., commonly referred to as U.S. Source business income and referred to by lawyers and accountants as Effectively Connected Income or ECI, is subject to the same tax on net income to which a U.S. person’s business income is subject, including the calculation of deductions and interest. A foreign corporation, however, is also subject to an additional tax called the Branch Profits Tax (unless a treaty provides otherwise), which explains why most foreign corporations do not do business directly in the United States.

C. Foreign Persons Foreign persons doing business in the United States generally have to file a few more forms than their United States counterparts with the Internal Revenue Service. (See, e.g., IRS Form 5472 and IRC §§6038A and 6038C) Partnerships and limited liability companies that have a foreign partner or member are subject to withholding on net Effectively Connected Income as to that partner or member. IRC §1446

D. Real Property (IRC §897) The disposition of a U.S. Real Property Interest (USRPI) owned by a foreign person (even through disposition of stock in a domestic corporation) is fully subject to tax upon its disposition under the Foreign Investment in Real Property Tax Act (FIRPTA) no matter what a treaty might say to the contrary. Most dispositions of a USRPI by foreign persons are subject to a 10 percent brut withholding tax for the Internal Revenue Service (IRC §1445) and, for example, a 3.33 percent brut withholding tax in the State of California. The withholding and payment of the tax to the IRS is to be done by the buyer of the real property.

When considering entering a new market, the first question to present itself is the choice of entity. Should it be a corporation? A partnership? What are the advantages and disadvantages of owning the foreign assets as individuals?

One can also use a branch of an existing U.S. company, even, for example, a Subchapter "S" corporation which, for U.S. tax purposes, is treated much like a partnership, i.e., only the shareholders – not the entity – are subject to tax on income. Such treatment is applicable for federal purposes, but not necessarily for state tax purposes. Clearly, foreign nations in which an "S" corporation operates through a branch, will treat it as a separate entity subject to corporate tax along with any applicable withholding (or branch) taxes upon distributions to the home office. The U.S. shareholders will get the benefit of a foreign tax credit for the withholding taxes and a deduction for the foreign income taxes paid by the branch.

The initial question in making such a determination is: what is the nature of the income such investment will produce? For example, if the investment will produce capital gains as distinguished from ordinary income from the conduct of a trade or business, the structure considered may be altogether different.

Example: Costa Rica does not tax capital gains of its taxpayers. A development group wishes to purchase prime beach-front properties to hold for development by related or third party entities. Sale of such appreciated properties, either to a related or unrelated entity, will generate capital gains which will not be subject to indigenous taxation. If the entity which acquired them is considered a pass-through entity (for U.S. tax purposes), the gain will be treated as having been received currently by the U.S. owner of the Costa Rican company. If the U.S. company is also a pass-through entity, such as a limited liability company, the gain will pass directly into the hands of the U.S. shareholders without interim tax liability, subject only to the current (twenty percent) tax rate on long term capital gains. The new U.S. check-the-box regulations will assist the taxpayer in making such a selection. Unless the foreign entity is considered a per se corporation (e.g., a plc (UK), A.G. (Germany), S.A. (France), etc.), which would not constitute a pass-through entity, such an election for U.S. purposes is easily facilitated.

Not every investment opportunity will produce such happy result. Often, it is the desire of the taxpayer to obtain the benefits of deferral of U.S. taxation until the foreign profits are ready to be repatriated. Here we get into the area of tension first mentioned above. The investor will probably need to operate through a corporate structure, for a pass-through entity will not provide any deferral because the income of the entity is treated as the income currently of its U.S. members. Neither would the investor be well advised to own the stock of a foreign corporate entity as an individual, as it would not benefit from the deemed paid foreign tax credit available to corporate shareholders.

A person subject to income taxes imposed by other countries may receive a credit against the U.S. tax such person must incur in respect of the same income. IRC §§901-908

U.S. taxpayers -- corporate or individual — who generate foreign source income which is subject to tax by a foreign jurisdiction are entitled to take a direct credit for those taxes under certain specific conditions. IRC §901.

The credit offsets U.S. (but not State) income tax that is assessed against that same income. For example, FC Ltd., an English limited company, pays UK taxes of thirty five percent on income of £100,000. It distributes the balance, £65,000 to its U.S. shareholders. If the shareholders are individuals each owning at least twenty-five percent of the shares of FC Ltd., the distribution will be subject to UK withholding tax at the lowest rate (five percent). After withholding the mandatory five percent withholding tax on the distribution, the U.S. shareholders would receive £61,750. Each of the shareholders would be able to deduct twenty-five percent of the tax withheld (the U.S. dollar equivalent of £812.50) against his or her own U.S. tax liability.

The Deemed Paid Credit is available to a U.S. corporate shareholder of a foreign corporation which receives a dividend from the foreign corporation. The U.S. corporation is entitled to take a deemed foreign tax credit of the foreign tax which the foreign corporation may have paid. IRC §902 Hence, in our prior example, if FC Ltd. were a subsidiary of a U.S. corporation, the U.S. corporation would gross-up the distribution it received from its subsidiary to £100,000, and offset its own federal tax liability with the UK corporate income tax paid by FC Ltd., i.e., £35,000, plus the tax withheld of £3,250, and credit the entire amount, viz., the U.S. dollar equivalent of £38,250, against its federal tax liability (roughly, the pound sterling equivalent of £34,000). The result would probably be excess foreign tax credits to be carried forward to future years, as the combined UK corporate and withholding taxes exceed the effective maximum U.S. corporate tax rate of thirty-four percent. This provides the U.S. parent corporation with an advantage that individual shareholders do not have, as the law deems the U.S. parent corporation as having paid the foreign tax itself.

The Code contains complex rules specifically limiting the extent of the foreign tax credit which the U.S. person can take. IRC §904 The rules are complex, but the basic concept is that a tax credit is allowed only against foreign income taxes or taxes in lieu of income taxes (i.e., property taxes, ad valorem taxes and other property-based taxes, such as extraction taxes, wellhead taxes, etc., are not eligible for a tax credit), and only when the income and foreign tax fall into the same basket, i.e., the same amount and character of income which was subjected to the foreign tax and which is included in the U.S. taxpayers’ tax return.

Very generally, the income which is taxed by the foreign jurisdiction must be foreign source income and the rate of tax on each basket of such income must not exceed the U.S. rate. Therefore, if a U.S. taxpayer’s only foreign source income is $100 of rent subject to $50 in foreign tax, but the U.S. tax on such income is only $31, the credit is limited to $31. (Doesn’t this conflict with the comment above concerning the ability of a US parent corporation to carry forward a deemed tax credit?)

The basic rule is that the ownership of shares of a foreign corporation is no different, for tax purposes, than ownership of shares of a U.S. corporation; that is, the corporation is the taxpayer and not the shareholder.

That rule changes, however, if the foreign corporation is controlled by a U.S. shareholder. The following rules that apply in that case are found in Subpart F of the Code. IRC §§951-964 and 1248.

1. If the corporation is a controlled foreign corporation (CFC), then certain income, referred to as Subpart F Income, which the CFC earns is deemed distributed as a dividend to the CFC’s U.S. shareholders.

2. A foreign corporation is a CFC if more than fifty percent of the stock of the corporation is owned or controlled by U.S. shareholders, directly or indirectly. IRC §957

3. Subpart F Income arises when the CFC is middleman in a purchase-sale/services transaction (as a general rule) or where a party related to the CFC is either on the buying end or the selling end of the transaction (referred to in the Code as Foreign Base Company Income. See, IRC §954). Various forms of passive income and certain investments in U.S. property by the CFC also create Subpart F Income.

4. Other foreign corporations to be aware of the income or shareholders of which may be subject to current U.S. taxation are the:

• Passive Foreign Investment Corporation (PFIC). See, IRC §§1291-1297); and
• Foreign Personal Holding Company (FPHC). See, IRC §§551-558.

Congress has also provided a number of corporations with special tax benefits in order to stimulate exports. Such entities include the:

• Domestic International Sales Corporation (DISC). See, IRC §§991-997
• Foreign Sales Corporation (FSC). IRC §§921-927.

The DISC is a U.S. entity, which may charge interest on export loans to related companies, the income stream for which receives favorable tax treatment. The FSC is a foreign corporation formed in a jurisdiction with which the U.S. has at least an Exchange of Information Agreement with respect to fiscal matters, the income from which is also subject to a special (favorable) tax regime. Currently, the FSC and its proposed replacement have been held by the WTO to provide US exporters an illegal subsidy. No valid replacement has as yet been cleared with the WTO.

The United States has entered into a series of income tax treaties with approximately forty countries throughout the world. All income tax treaties override inconsistent Internal Revenue Code provisions passed before the treaty’s notification. For example, if the Internal Revenue Code requires withholding tax of thirty percent on interest, but the treaty provides for five percent, then the appropriate rate is five percent not thirty percent. Also, merely doing business is not enough for taxation. A treaty resident must also operate through a Permanent Establishment (or PE) to be subject to tax in the host country.

Tax treaties benefit residents of the two countries, including corporations, although frequently the treaty contains a limitation on benefits provision which requires the corporation, in order to be entitled to treaty benefits, to be owned more than fifty percent by individual residents of the treaty country. Thus, tax avoidance via manipulation of tax treaties is made much more difficult as a result of such limitations. For example, it was at one time possible to invest in the Netherlands by way of the Netherlands Antilles which was covered by a separate protocol to the Netherlands/U.S. Tax Treaty. There was a zero rate of withholding out of the Netherlands to the Netherlands Antilles and out of the latter to the U.S. Likewise, a European finance subsidiary could be set up in Switzerland to finance the operations of the Netherlands company, stripping its earnings of the interest which would go to the Swiss company to be taxed at a maximum thirteen and one half percent rate. The Netherlands entity was structured so as to fall within a maximum twelve percent tax rate there, and the sums distributed to the Antilles company were taxed, if at all, at a maximum three and one half percent rate. Such activities are called basis-stripping and the European Union (EU) and the U.S. have cooperated in a number of measures to delimit this phenomenon, including replacing old tax treaties with newer models containing stricter rules for benefits.

A. Source of Income is, for example, income from services performed or for the use of property (tangible or intangible) inside of the U.S., e.g., rents for property located inside the U.S. Foreign Source Income is basically all non-U.S. Source Income. IRC §§861-865 The source of income is most important for U.S. persons for purposes of calculating the Foreign Tax Credit and for foreign persons for purpose of determining what income is subject to U.S. tax. Id.

B. Nonrecognition of Gain (also referred to as tax free treatment) resulting from transfers (especially of intangibles) to foreign organizations and corporate reorganizations involving foreign entities is often denied. IRC §§367 and 482 The concern, of course, is that income producing assets or businesses will be transferred beyond the fiscal reach of the U.S. and full recognition of gain and other income is required as part and parcel of the transfer. Moreover, the transfer of an intangible, such as a valuable trademark or other intellectual or industrial property right, will be ignored and the sales price treated merely as an advance against arm’s length license fees or royalties for such use during the life of the intangible. IRC §482 and accompanying Regulations.

C. Transfer Pricing. The IRS can challenge the pricing of sales and services between or among related domestic and foreign entities to avoid the manipulation of the amounts of U.S. or foreign source income generated. Id. The regulation of related party sales and services is one of the more complex in the Code and is known, generically, as the Transfer Pricing Regulations.

Assumption: A U.S. and Japanese company are considering a joint venture to establish a factory in China in which to make a product which the U.S. company and the Japanese company have both made, but for different purposes and tolerances. Both companies seek to exploit their joint technologies in China, to sell to others there and to export such technologies to the rest of the world. Focusing only on the tax aspects, the U.S. company will need to address the following questions:

1. Will the joint venture be a CFC (i.e., will the U.S. party own or control more than 50% by value or voting power?) If so, the provisions of Subpart "F" must be observed.

2. If the joint venture is to be truly 50/50 or the U.S. party will own less than 50%, the CFC problem will not arise, but managerial concerns, imputed income from receipt of high value shares for the contribution of low basis intellectual property, and control of contributed intangibles will be a problem. It may be necessary for each party to form its own PRC subsidiary, contribute the intangibles to its own subsidiary and have the subsidiaries enter into a venture with or without a Chinese partner.

3. The development portion of the joint venture will entail cost sharing which must comply with the Transfer Pricing Regulations, and which may even require a buy-in by the Japanese joint venturer if the contribution of the U.S. party is of greater value. Likewise, the price at which the Chinese joint venture sells to its U.S. partner may well have to comply with the Transfer Pricing Regulations, especially if the joint venture (or joint venture partner) is considered a CFC.

4. If the venture should fail, the tax effects of dissolution can be devastating, especially if there is any forgiveness of indebtedness (which creates income to the U.S. party). IRC § 61(a)(12). The Code continues to distinguish between ordinary and capital losses. Capital losses receive less favorable treatment, being allowable only against capital gains. Ordinary losses may be used to set off both ordinary income and capital gain. Hence, depending upon whether the losses are ordinary or capital, and whether the venture had made, for example, an IRC § 754 election at the time a new partner, bought in at a stepped-up basis, the eventual liquidation may result in such partner receiving both capital loss and ordinary income, the latter not being offset by the former. Moreover, if the liquidation occurs in, say, the year after the income is realized, the loss may be carried back three years in the case of a corporate partner, and not at all in the case of an individual.

This, in effect, brings us back full circle to the initial caveat. We have dealt with only some of the U.S. tax consequences for U.S. taxpayers engaging in international transactions, and have only scratched the surface when it comes to the foreign laws and regulations that apply to foreign ventures. One thing is for certain, doing business outside of the U.S. is not at all like doing business entirely within its borders. It is difficult enough to do the latter; when venturing beyond the frontier, the problems are infinitely more complex. Hence, counsel should not neglect the need for competent tax advice, especially if they are unfamiliar with the issues.

Basket - category of income used in the foreign tax credit limitation context.

CFC - a controlled foreign corporation; a foreign corporation over 50% of the stock of which is owned by U.S. shareholders (U.S. persons owning 10% or more of the corporation).

Deemed Paid Credit - credit for foreign taxes paid by a foreign subsidiary of a domestic corporation which the domestic parent is treated as having paid.

DISC - Domestic International Sales Corporation. IRC §992.

Effectively Connected Income or ECI - refers to income earned by a foreign person actively engaged in a trade or business in the United States.

Expatriate - refers both to a person who is a U.S. citizen but living and working overseas, and to a former U.S. citizen who has renounced his U.S. citizenship.

FIRPTA - Foreign Investment in Real Property Tax Act contains the special rules on taxation of foreigners who dispose of U.S. Real Property Interests (see, below).

FSC - Foreign Sales Corporation. IRC §992.

Foreign Personal Holding Company (FPHC) - IRC §552.

NRA - Non-resident alien - individual who is neither a citizen nor a resident of the U.S.

Permanent Establishment (PE) - the place of business inside a host country that is a party to an income tax treaty.

PFIC - Passive Foreign Investment Corporation - a foreign corporation with U.S. investors which earns passive income.

Subpart F Income - the types of income of a CFC which are subject to immediate tax by the U.S. described in Subpart F of the Code.

USRPI - U.S. Real property interest, usually refers to U.S. real property or interests in a U.S. entity the predominant assets of which are U.S. real property.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.