Frequently I'll get asked at a conference or seminar about the issue of paying or not paying current income taxation on international earnings. Many people believe that if they generate money outside the US and do not repatriate that money, they owe no tax. But the issue is significantly more nuance and complicated and for most people investing offshore, this belief is just plain wrong.

The US IRS divides the world of how things get taxed into four basic quadrants. On one axis is the concept of domestic income versus foreign income. On the other axis we have passive income versus active income. Only the quadrant that lines up both foreign and active qualifies for legal tax deferral, meaning that money is taxed in the US at the time that it is distributed to shareholders rather than the year in which it is earned. I suspect many international businesses could fit into this quadrant, while most types of passive investments will not.

This one quadrant is often referred to as a "loop hole" because multi-national corporations like Apple or Google can amass billions of dollars offshore on a pre-tax basis. Of course it is not really a loop hole because in most cases they have paid at least some taxes in the country in which they are operating and when the money is repatriated it is often taxed twice (once at the corporate level and the second time at the individual level). So there are solid financial reasons for companies doing business abroad to organize their affairs into this category and delay paying taxes as long as possible. Essentially, these companies can build and expand their foreign operations on a "pre tax" basis.

To the extent that a company is doing work outside the US and being paid by foreign sources, it qualifies to build up its pre tax money at the corporate level and legally defer paying tax almost indefinitely. (Hence the "loop hole" claim by politicians).

Now, tax in the foreign jurisdiction where the company is operating, is another matter. Generally, other countries tax their corporate and individual clients based on "residence" not citizenship. This means simply that if you live somewhere (or in the case of a company are domiciled there) you pay local taxes. Frequently, however, the tax only applies to income generated in the jurisdiction. This means that income generated outside the jurisdiction is not subject to taxation. The US, on the other hand taxes their individual citizens and corporations based on citizenship, not residence, so finding ways to legally defer tax is much more difficult for an American than say a German (who pays no tax on his income from sources outside Germany).

There are basically three types of tax systems in the world, which I would categorize as:

1) Developed, world, high taxes. I would put the US, Japan, Korea as well as most European countries, Australia and New Zealand into this category. While the taxes in these jurisdictions are high, they also have what are called "double tax treaties" that are designed to make sure you don't pay taxes twice. So, if for example you set up shop in Korea and pay a Korean tax of 30 percent, that would be a credit against your US tax. So if your US rate was 35 percent, you'd pay Korea 30 percent and then 5 percent more to the US. You'd be in basically the same position as if you were working solely in the US.

2) There are "no tax" or "low tax" jurisdictions, which are primarily the jurisdictions that many lawyers, accountants and asset protection specialists use in structuring classic "offshore structures". These jurisdictions include Belize, Panama, Caymans and in Asia, Hong Kong and the Cook Islands. These are the jurisdictions that the multi-national companies utilize for tax deferral on their non US source income. Another very solid low tax jurisdiction is Singapore. Singapore exempts lots of different types of income from taxation and have a marginal tax rate on the rest that maxes out at 10 percent. They also have a solid judiciary and English common law foundations that are comfortable for Americans to work in which is important when doing business in Asia. Malta is another example of this type of jurisdiction and you can end up with an effective tax rate of 3-4 percent on money which you earn there.

The third category is what I would call high tax countries which can be used like tax havens because of their tax sourcing rules that makes nearly all tax earned outside their jurisdiction non taxable. Costa Rica is an example that comes to mind. They don't tax anything except income generated inside the country. The way they interpret that definition excludes most international types of income. So, for example much of the offshore internet gambling industry has been established there because even though the servers are based in CR, the Government deems the income as being earned somewhere else. So, for example if you based an international diving business in Costa Rica, you'd pay taxes when someone walked into your shop and paid you to take them out on a dive. All other income from outside Costa Rica (say charters to Belize or Panama) would not be subject to Costa Rican taxation, so you might end up with a very low overall tax rate (or even zero if no business was done inside Costa Rica).

It has become and is becoming increasing difficult to move funds out of (not so much into) the US. New laws starting with the Patriot Act, and most recently FATCA (Foreign Account Tax Compliance Act), force banks and individuals into more and more reporting to ensure that tax is paid on income. My advice on doing international business is first to minimize superfluous transactions by having a good corporate structure and bank account in the region where you are doing business so not every 100 dollar transaction needs to go through the US. Next, you need to use a good accountant familiar with the various reports that are required. The forms are not rocket science, but failure to file (even when you don't owe any tax) can bring about large fines and penalties. The main reports for individuals includes FBAR (Foreign Bank Account Report), 8938 Ownership of US owned assets abroad, Form 5471 Corporate information return on foreign activities and Form 3520 for assets held in a foreign trust. These forms are not significantly more difficult that preparing domestic tax forms, but because they are different, it is important that you work with someone familiar with their preparation.

International business can be exciting and certainly profitable. Knowing how to structure your business and personal affairs so as to protect your assets while minimizing and deferring taxation, can truly make the difference in any project's overall financial success.