Separating Fact from Fiction in Global Business and Investment
I spoke at a conference in Florida recently and during the Question & Answer session after my speech, one of the attendees asked me “what was the most erroneous assumption made by folks with regard to international business and investment”?
“The timing of taxation on global profits”, was my immediate response. You see, many people operate under a false assumption that if they make money abroad, they only pay taxes when they bring their money back into the United States. And while that may be the case in certain limited circumstances (which we will discuss below), the assumption as a starting point for global business and investment is false.
Actually, the starting point for US citizens engaged in any activity outside of the United States is the complete opposite. The United States taxes its citizens based solely on their “citizenship.” Most other developed countries such as Canada, UK or Germany, tax their citizens based on “residency” rather than citizenship as well as “where” the income is earned.
The US position, however has always been that the benefits of US citizenship follow each US person around the globe and therefore they are subject to United States taxation on their worldwide income regardless of residency or source of income. Exceptions are made for both real persons and corporations, living and doing business abroad in certain limited circumstances, but when those circumstances do not prevail, the general rule is what controls the issue of taxability.
So what are the Specific Circumstances in Which Income Is Tax Deferred or Tax Free and When do They Apply?
Individuals ~
The Tax Code allows an annual exclusion of income to individuals in basically one circumstance, where two criteria are met. First, the individual must be a bona fide resident of a foreign country, not exceeding the permissible number of days permitted by the IRS inside the United States. If you fail this prong of the test because you either are not a foreign resident or because you spend too much time in the United States, then you do not qualify for the exclusion.
Secondly, if you do meet the residency and time requirements of the first prong, then the IRS looks at the source (i.e. the “where”) of the income. It must be from a foreign source outside of the United States AND the income must be “active” income rather than “passive.” So, passive foreign investment received outside of the United States will never generate income, subject to any tax exclusion or deferral.
If you meet both elements of a US non-resident person with foreign source active income, then you are eligible to file Form 1040NR when you do your taxes instead of Form 1040. The Form 1040NR has an exclusion amount of approximately $92,000 plus another $13,000 in foreign housing expense that is exempt from taxation. So in the right circumstances an individual can receive up to just over $100,000 in tax free income.
Corporations ~
In the case of corporations, several elements again control whether current taxation is due or whether it may be legally deferred. First, we look to the nationality of the corporation to determine where it should be taxed. After all a corporation is a legal or juridical “person” which takes on the nationality of where it is incorporated.
The US Tax Code looks, however, through the nationality of the corporation to the underlying shareholders. If the majority of the corporation is owned by United States shareholders, then the corporation is deemed to be a “CFC” (Controlled Foreign Corporation). When a company has the CFC designation, the IRS disregards the legal nationality of the company’s incorporation and pulls the company into the US tax system.
If the company is a CFC, then the next issue is to examine whether the income the company generates is “passive” or “active.” In the case of active income, the CFC can retain income at the corporate level, and no immediate taxation occurs to the underlying United States shareholders until a distribution occurs. This allows foreign corporations owned by US shareholders, who are engaged in active business, to legally grow their company on a pre-tax basis. This is the loophole politicians are presently arguing over as it pertains to many Fortune 500 companies and other smaller companies doing active business abroad. To the extent that the company does earn foreign source active income, there is no limitation on the amount of income or the length of time that such income can be deferred.
When a company operating outside of the United States generates “passive” income, however, this is not the case. Instead, the CFC is designated as a PFIC or Passive Foreign Investment Company. A PFIC designation occurs anytime more than 25% of the company’s foreign income is derived from “passive” sources. In the case of a PFIC, the underlying US person owning ANY shares in the company are responsible for their ratable share of income taxation, even where no income distribution occurs. In that scenario, the US shareholder owes tax on money they have not even received. This is sometimes referred to as “phantom” income.
In conclusion, it is important to understand the residency rules, source income rules, and type of income being generated to determine whether any tax free or tax deferred income is being generated or received by a United States person. For most individuals looking to protect assets and make investments abroad there is no tax benefit to operating outside of the United States. There may be other benefits such as currency diversification or protection from creditors or more freedom in estate planning, but the belief that a US person can gain a tax benefit simply by taking an asset offshore and keeping it there is undeniably an erroneous assumption.
