Presentation: U.S. Citizens Investing & Doing Business Abroad

U.S. Taxation Issues and Residence

  • The U.S. Taxes U.S. citizens and residents.
  • U.S. Citizens are subject to U.S. Tax law regardless of where they live.
  • U.S. passport applications may be denied if tax returns have not been filed.
  • U.S. citizens self employed abroad may be exempt from self employment (social security) tax in the U.S. if they live in a country with a Totalization Agreement.

Active and Passive Income

  • Active income is the conduct of a trade or business venture. This may be done through a U.S. entity or through a foreign entity.
  • Passive income includes net rentals, interest, dividend, capital gains and investment
  • income.
  • A foreign entity earning active income is normally only taxable in the foreign country.
  • Passive income earned through a foreign entity controlled by U.S. persons is subject to subpart F of the Internal Revenue Code, and must be included in personal (1040) income of shareholders even if income is not distributed to you.
  • Passive income earned abroad through a U.S. entity is dealt with according to U.S. rules (after foreign taxes are paid).

What is Subpart F

  • Subpart F of the Internal Revenue Code requires US citizens & residents to include in
  • personal income, the income of a “controlled foreign corporation”.
  • This means that all passive income (interest, dividends, net rental income) earned by a
  • foreign corporation is included in your 1040 each year, REGARDLESS OF WHETHER THE AMOUNT HAS BEEN PAID OUT OF THE FOREIGN CORPORATION TO YOU.
  • Form 5471 must be filed with your 1040 each year. ($10,000 fine per year if not.)
  • Form 5471 discloses all details of income and expenses, assets and liabilities and other
  • information regarding the foreign corporation.
  • Direct and indirect (through a U.S. entity) investments are treated the same.
  • Incorporating a foreign entity to provide personal services in the U.S. or in a third country triggers subpart F.
  • The bottom line: You cannot incorporate a foreign corporation to accumulate passive income without including that income on your 1040 each year.

Direct and Indirect Investments

  • U.S. person who owns a foreign entity directly – must file form 5471 and follow subpart F rules;
  • U.S. entity and U.S. person both must file form 5471 due to indirect holdings of foreign entity.

US Tax Law and Foreign Entities

  • U.S. rules, apply to U.S. citizens and residents who own foreign entities:
    • Accumulated earnings tax prevents accumulation of income abroad without being taxed in the U.S.
    • Like kind exchanges may not work in foreign countries. 
    • Flow through rules may not work in foreign countries.
    • Watch for personal holding company tax in the U.S.

Using a U.S. Entity Abroad

  • U.S. entity with a permanent establishment abroad may be subject to tax in foreign country.
  • U.S. entity doing business abroad must file tax returns in the foreign county (as well as in the U.S.)
  • U.S. entity normally needs to apply for permission to be recognized in a foreign country – (Important – Since you don’t want to own property abroad through an entity the foreign country does not recognize.
  • U.S. entity subject to audit by foreign authorities.

Incorporating a Foreign Entity

  • Each country has it’s own set of laws pertaining to corporations – and they are not always consistent with U.S. law. – ie: Local resident director requirements; control by local residents.
  • Your U.S. entity can own a foreign entity.
  • If “mind and management” of the foreign entity is in the U.S., then you may be able to pay a management or administration fee to the parent entity. This reduces the taxable income of the foreign entity.
  • Management fees and other payments may be subject to non resident withholding tax – depending on our Treaty with that country.
  • Management fees and other payments cannot be arbitrary, and must be justified – by amount of work or benefit provided to the foreign entity.
  • Most Treaty countries have a preferred rate of withholding on dividends paid to a controlling parent corporation.
  • Foreign entity files taxes locally and is subject to liability law locally.
  • Losses incurred in a foreign entity likely cannot be used in the U.S.

Basis of Taxation – Review

United States
  • The U.S. Taxes U.S. citizens and residents.
  • U.S. Citizens are subject to U.S. Tax law regardless of where they live.
  • U.S. persons who own foreign corporations are subject to subpart F of the Internal Revenue Code – and must file form 5471.
  • U.S. Citizens who own foreign investments – U.S. Tax law applies to foreign corporations.
Other Countries
  • Most countries base taxation on residence, not citizenship.
  • Spending > 183 days in a country likely means you are a resident – and taxable there on world income.
  • Important to define active vs. passive income earned abroad.
  • A U.S. corporation can be considered a resident of a foreign country.

Factors Determining Residence

Factors Determining Tax Residential Status Abroad (Can determine if you are taxable in foreign country):
  • Permanence and purpose of being abroad.
  • Residential ties to foreign country:
    • Location of dependents.
    • Banking arrangements.
    • Investments.
    • Drivers License.
    • Health Insurance.
    • Club Memberships.
  • Residential ties abroad
  • Visa status in foreign country
  • Source of income
  • Regularity and length of visits to foreign country;
  • You must be resident somewhere
  • Treaty – Tiebreaker provisions used.

Claiming Foreign Tax Credits

  • Foreign taxes may either be deducted or claimed as a credit on form 1116;
  • Credit is better – foreign tax deducted from U.S. tax liability.
  • Tax credits are only available on the same class of income the tax was paid on;
  • Credit may not be claimed on excluded income (Sec 911);
  • Unused foreign tax may be carried forward for 6 years.

Treaties and Real Estate Sales

  • Real property interests are considered separately from other capital gains.
  • Real property dispositions are always taxable first in the country where the property is, and then in the U.S.
  • Foreign tax credits apply to U.S. taxes if foreign capital gains tax was paid.
  • Foreign capital gains rates and rules may not be the same as those in the U.S., so:
    • You may not get credit for all of the foreign tax paid (since it is higher than the U.S. capital gains rate;
    • You may have unused foreign taxes available for carryover.

Offshore Tax Shelters?

  • Most “offshore tax shelter” plans involve earning passive income in a foreign entity
  • The link between the U.S. shareholder and the foreign corporation is hidden through the use of a “trustee”.
  • Most of these schemes are illegal since they require that you not disclose your real relationship with the investment.
  • Proper disclosure gives rise to subpart F income.
  • RISK: Loss of investment or serious tax penalties.
  • DON’T DO IT

Foreign Earned Income Exclusion

  • Can exclude up to $82,000 for 2007;
  • Earned income only;
  • Each spouse may claim a separate exclusion;
  • Must establish Bona fide residence or meet physical presence test;

Bona Fide Residence& Physical Presence Test

Bona Fide Residence
  • Must be in foreign country for at least one calendar year;
  • Must have intent to live in foreign country;
  • Temporary trips home will not affect qualification;
  • Must be a tax resident and subject to tax in foreign country to qualify.
Physical Presence
  • Must be present abroad for 330 out of 365 days;
  • Same overlapping months may be used to qualify;
  • For example.. Period 1 is May through March of next year, and period 2 is January through December of year 2.
  • Proportional exemption claimed for part year away.

Summary: Eliminating Double Taxation

  • Treaty Provisions override income tax laws.
    • Forms must be filed (8833) to disclose the Treaty provision being relied on – and to explain the tax rule overridden.
  • Foreign Tax Credits are available to prevent double taxation on the same income;
  • Foreign Earned Income Exclusion – only available if you live outside the U.S.;
  • Do you claim FTC or Earned Income Exclusion –(Now EIE comes off the bottom of your income leaving higher taxed income intact)?
  • Watch out for Alternative Minimum Tax.

Summary of Pitfalls: Investing Abroad

  • Use of a foreign entity to earn passive income can result in subpart F income inclusion;
  • Many countries have “deemed disposition” rules triggering capital gains earned while in country (when you depart) – regardless of whether you sell the asset.
  • Don’t expect that all investment rules and laws are the same as at home.
  • Make sure you have the appropriate visa to operate in the foreign country – failure to so may result in a loss of your investment.
  • Follow all local licensing rules.

Revoking U.S. Citizenship

  • Not so fast.. IRC 877 taxes U.S. citizens for 10 years after citizenship revoked.
  • IRC 877 only applies where expatriation is due to tax.
  • If assets > $500K or tax liability >$100K then tax reason is assumed by IRS.
  • Specially modified return listing all assets in year of expatriation.

Estate Taxation

  • U.S. Estate taxation applies to expatriate estates and world assets.
  • Fair market value of foreign entity is included in your gross estate.
  • No foreign tax credit for foreign capital gains tax on death – but tax may be deducted from gross estate.

IRS Notice

To ensure compliance with requirements imposed by the Internal Revenue Service, we inform you that any tax advice contained in the body of this presentation and any attachments was not intended or written to be used, and cannot be used, by the recipient (a) for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code or applicable state or local tax law provisions and (b) for the purpose of promoting, marketing, or recommending any tax-related matters addressed within to another party.

This presentation and any attachments may contain privileged, proprietary and/or confidential information. The distribution, disclosure, viewing or use of this communication and any attachments by any person other than the intended recipients is strictly prohibited. If you have received this communication in error please immediately notify the sender and delete this communication and any attachments from your computer.

Thank You

This presentation has been made courtesy of Mark T. Serbinski, Certified Public Accountant and Serbinski Partners PC, Chartered Accountants

Creative Solutions to Cross Border Income Tax Issues

More information online: Serbinski.com

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