By Kenneth H. Bridges, CPA, PFS June 2016
We are often asked by our U.S.-based clients who are considering conducting business outside the U.S. to advise them with respect to the tax consequences of such. Likewise, we are often asked to advise non-U.S. based companies which are looking to establish a presence in the U.S. The U.S. rules in this area are highly complex, and you also have to look to the tax rules of the other country, as well as to any tax treaty between the U.S. and such other country. With that caveat, a general overview is as follows.
Worldwide tax system – The U.S. taxes its citizens and residents (including domestic corporations) on their worldwide income, from whatever source derived. The U.S. generally permits a credit (the “foreign tax credit”) against U.S. tax for taxes properly paid to other countries on income sourced to such other countries, so long as the effective rate paid to the other country does not exceed the effective rate paid to the U.S. on that same income. Any excess foreign tax paid becomes a carryforward to future years.
Other countries’ tax systems – The tax systems of other countries vary, but most countries have a tax on income similar to the U.S. income tax. To the extent that a U.S. company, citizen or resident conducts business in another country, such foreign country will generally subject the income to its income tax, unless an exception is met or you are protected from that country’s income tax under the treaty between the U.S. and the foreign country.
Tax treaties – In order to reduce the risk of duplicate taxation and to encourage international commerce, the U.S. has an income tax treaty with most major countries. A typical treaty provision provides that a U.S. resident or company is not subject to the other country’s income tax on income from business conducted in the foreign country, so long as the U.S. resident or company does not have a “permanent establishment” (which generally means a fixed place of business) in the foreign country. In the case of an individual, the U.S. resident is generally not subject to tax in the foreign country so long as he or she is not present in the country for more than 183 days during the year (unless on the payroll of a foreign company, in which case the salary is typically subject to tax in the foreign country if over a fairly small amount). Other typical treaty provisions provide for a reduced or zero rate of withholding on interest, dividends, rents, royalties and other types of passive income paid by a resident of one country to a resident of the other.
Totalization agreements – The U.S. has agreements with many countries whereby U.S. employees going abroad pay social security tax only to the U.S. government or, if they instead pay social security tax to the foreign government, they get credit within the U.S. social security system for the social security tax paid to a foreign government.
Foreign earned income exclusion – A U.S. citizen working abroad may be able to exclude up to $101,300 of his foreign earned income plus up to $16,208 of housing costs from U.S. tax if certain requirements are met. In order to be eligible for this exclusion you must either be a resident of a foreign country(s) for an uninterrupted period which includes an entire tax year or remain outside the U.S. for at least 330 full days during a period of 12 consecutive months. To the extent that the foreign country has an income tax rate as high or higher than that of the U.S., little benefit is likely to be gained from this provision (since the foreign taxes paid would likely be creditable against the U.S. tax otherwise due). However, if you are working in a foreign country with little or no income tax, this provision can be very beneficial.
Controlled foreign corporations – While a U.S. company is subject to U.S. tax on its worldwide income, the income of a foreign subsidiary of a U.S. company is not necessarily subject to U.S. tax, provided the income is from the active conduct of a business in the foreign country. Passive type income (e.g. interest, dividends, and rents) typically will be subject to current U.S. tax even if in a foreign subsidiary, as will earnings of the foreign subsidiary invested in U.S. property or any earnings actually distributed back to the U.S. parent company or shareholders. In some cases, it is advantageous to structure your foreign operations through an entity that will be recognized as a corporation in the foreign jurisdiction, but treated as a flow-through entity for U.S. tax purposes. This can be advantageous if losses are anticipated from the foreign business which you wish to deduct against U.S. income or as a way of minimizing duplicate taxation (especially if the U.S. parent company is a flow-through entity). In other cases, especially if the business will be subject to little or no tax in the foreign jurisdiction and has a need to accumulate capital, it can be more advantageous to structure the business through a foreign entity that will be treated as a C-corporation for U.S. tax purposes. To the extent that a foreign corporation is controlled by U.S. persons, there are annual reporting requirements with the IRS (Form 5471) to enable the IRS to monitor the ownership and financial activities of the foreign corporation and any transactions it has with its U.S. owner(s).
U.S. corporation with foreign ownership – A U.S. corporation which has a 25% or more foreign shareholder must file a Form 5472 with the IRS each year disclosing such ownership and detailing any transactions it has with its foreign shareholder or other foreign affiliates.
Transfer pricing – In order to prevent arbitrary shifting of income between U.S. companies and their foreign affiliates, tax rules require arms-length transaction pricing for purchases of goods and services between related companies.
Interest stripping and thin capitalization – In order to limit the ability of a foreign company to minimize or eliminate its U.S. tax by capitalizing is U.S. subsidiary primarily with related party loans, tax rules limit the U.S. company’s interest expense deduction if its debt to equity ratio exceeds 1.5 to 1. Also, tax rules permit U.S. Treasury to issue regulations treating some intercompany loans as equity, and the IRS has recently issued controversial proposed regulations in this area.
Corporate inversions – In order to avoid U.S. tax on the repatriation of earnings, U.S. multinational corporations have left substantial earnings offshore in foreign subsidiaries. This lack of flexibility, however, has led some U.S. companies to “expatriate” to a country with a lower corporate tax rate and a territorial tax system. In a “corporate inversion” transaction, a U.S. company effectively acquires a non-U.S. corporation, but the transaction is “inverted” whereby the foreign corporation ends up as the parent company owning the stock of the U.S. company, but with the former shareholders of the U.S. company now owning most of the stock of the foreign company. The IRS has taken steps in recent years to make corporate inversions more difficult to accomplish.
Foreign bank and financial accounts – Any U.S. person with a financial interest in or signature or other authority over a foreign financial account must file with the Treasury Department each year by June 30 a Form FinCEN 114, disclosing the details with respect to such accounts, if the aggregate balance of such accounts at any time during the prior calendar year exceeded $10,000. A separate form (Form 8938) which somewhat overlaps with the FinCEN 114 may need to be attached to your income tax return. The penalties for failure to comply with these disclosure rules can be draconian.
Kenneth H. Bridges, CPA, PFS is a partner with Bridges & Dunn-Rankin, LLP an Atlanta-based CPA firm.
This article is presented for educational and informational purposes only, and is not intended to constitute legal, tax or accounting advice. The article provides only a very general summary of complex rules. For advice on how these rules may apply to your specific situation, contact a professional tax advisor.